EQUILIBRIUM DESTABILIZED: FIDUCIARY DUTIES UNDER THE UNIFORM LIMITED LIABILITY COMPANY ... · 2017-12-21 · Before 1990, Florida and Wyoming were the only LLC jurisdictions. Rob-ert

* Copyright © 1995 Claire Moore Dickerson and Stetson Law Review.** Professor of Law, St. John's University; A.B., Wellesley College, 1971; J.D.,

Columbia University, 1974; LL.M. in Taxation, New York University, 1981.1. See, e.g., Henry N. Butler & Larry E. Ribstein, Opting Out of Fiduciary Duties:

A Response to the Anti-Contractarians, 65 WASH. L. REV. 1 (1990) (discussing the issue inthe corporate-law context).

2. See, e.g., John C. Coffee, Jr., The Mandatory/Enabling Balance in Corporate Law: An Essay on the Judicial Role, 89 COLUM. L. REV. 1618 (1989) (advocating a tem-pered support of fiduciary duties). See also infra Part II(B)(2) for a reference to anti-contractarians as supporters of mandatory fiduciary duties.

3. As of August 1995, 47 states and the District of Columbia have adopted such astatute. ALA. CODE §§ 10-12-1 to -61 (Supp. 1993); ALASKA STAT. §§ 10.50.010–.995(Supp. 1994); ARIZ. REV. STAT. ANN. §§ 29-601 to -857 (Supp. 1994); ARK. CODE ANN. §§4-32-101 to -1316 (Michie Supp. 1993); CAL. CORP. CODE §§ 17000–17705 (West Supp.1995); COLO. REV. STAT. ANN. §§ 7-80-101 to -1101 (West Supp. 1994); CONN. GEN. STAT.ANN. §§ 34-100 to -242 (West Supp. 1995); DEL. CODE ANN. tit. 6, §§ 18-101 to -1107(1993); D.C. CODE ANN. §§ 29-1301 to -1375 (Supp. 1995); FLA. STAT. §§ 608.401–.514

EQUILIBRIUM DESTABILIZED: FIDUCIARYDUTIES UNDER THE UNIFORM LIMITEDLIABILITY COMPANY ACT*

Claire Moore Dickerson**

I. INTRODUCTION

Fiduciary duty is a thorn in the side of the law and economicsschool;1 to other scholars, it is an indispensable, and even efficient,aspect of the business form.2 What should be the standard for per-formance of a member in a limited liability company (LLC), a newstyle of business organization? How should we determine the impactof being both a member and a manager?

The analysis of the LLC is both difficult and interesting pre-cisely because it is, for the United States, a new form defined andcreated by statute. The limited liability company statutes havespread from one jurisdiction to another with remarkable speed.They promise limited liability for every owner, even owner-manag-ers, and at the same time offer federal tax treatment as a partner-ship. This combination is irresistible: forty-seven states and theDistrict of Columbia have adopted LLC statutes; before 1988 therewere only two such jurisdictions.3 The National Conference of Com

418 Stetson Law Review [Vol. XXV

(1993); GA. CODE ANN. §§ 14-11-100 to -1109 (1994 & Supp. 1995); IDAHO CODE §§ 53-601to -672 (1994 & Supp. 1995); ILL. ANN. STAT. ch. 805, para. 180 (Smith-Hurd Supp.1995); IND. CODE ANN. §§ 23-18-1-1 to -13-1 (West 1994); IOWA CODE ANN. §§490A.100–.1601 (West Supp. 1995); KAN. STAT. ANN. §§ 17-7601 to -7652 (Supp. 1993);KY. REV. STAT. ANN. §§ 275.001–.455 (Michie/Bobbs-Merrill Supp. 1994); LA. REV. STAT.ANN. §§ 12:1301–:1369 (West 1994); MD. CODE ANN., CORPS. & ASS'NS §§ 4A-101 to -1103(1993 & Supp. 1994); ME. REV. STAT. ANN. tit. 31, §§ 601–762 (West Supp. 1994); MICH.COMP. LAWS ANN. §§ 450.4101–.5200 (West Supp. 1995); MINN. STAT. ANN. §§322B.01–.960 (West 1995); MISS. CODE ANN. §§ 79-29-101 to -1201 (Supp. 1994); MO.ANN. STAT. §§ 347.010–.187 (Vernon Supp. 1994); MONT. CODE ANN. §§ 35-8-101 to -1307(1994); NEB. REV. STAT. §§ 21-2601 to -2653 (Supp. 1994); NEV. REV. STAT. ANN. §§86.010–.571 (Michie 1994); N.H. REV. STAT. §§ 304-C:1 to :85 (Supp. 1994); N.J. STAT.ANN. §§ 42:2B-1 to -70 (West Supp. 1995); N.M. STAT. ANN. §§ 53-19-1 to -74 (MichieSupp. 1994); N.Y. LTD. LIAB. CO. LAW §§ 101–1403 (McKinney Supp. 1995); N.C. GEN.STAT. §§ 57C-1-01 to -10-07 (1993 & Supp. 1994); N.D. CENT. CODE §§ 10-32-01 to -155(Supp. 1993); OHIO REV. CODE ANN. §§ 1705.01–.58 (Anderson Supp. 1994); OKLA. STAT.ANN. tit. 18, §§ 2000–2060 (West Supp. 1995); OR. REV. STAT. ANN. §§ 63.001–.990 (Supp.1994); 15 PA. CONS. STAT. ANN. §§ 8901–8998 (Supp. 1995); R.I. GEN. LAWS §§ 7-16-1 to -75 (1992 & Supp. 1994); S.C. CODE ANN. §§ 33-43-101 to -1409 (Supp. 1995); S.D. CODI-FIED LAWS ANN. §§ 47-34-1 to -59 (Supp. 1995); TENN. CODE ANN. §§ 48-246-101 to -602,48-248-101 to -606 (Supp. 1994); TEX. REV. CIV. STAT. ANN. Art. 1528n, arts. 1.01–11.07(West Supp. 1995); UTAH CODE ANN. §§ 48-2b-101 to -158 (1994 & Supp. 1994); VA. CODE

ANN. §§ 13.1-1000 to -1123 (Michie 1993 & Supp. 1995); WASH. REV. CODE ANN. §§25.15.005–.902 (West Supp. 1995); W. VA. CODE §§ 31-1A-1 to -69 (Supp. 1994); WIS.STAT. ANN. §§ 183.0102–.1305 (West Supp. 1994); WYO. STAT. §§ 17-15-101 to -143 (1989& Supp. 1995). Before 1990, Florida and Wyoming were the only LLC jurisdictions. Rob-ert R. Keatinge et al., The Limited Liability Company: A Study of the Emerging Entity,47 BUS. LAW. 375, 378 (1992). National Conference of Commissioners on Uniform StateLaws' (NCCUSL) Uniform Limited Liability Company Act (ULLCA) was approved July29–August 5, 1994, at NCCUSL's annual conference. Since then, the ULLCA has beenrevised several times, the last on August 11, 1995.

4. UNIF. LTD. LIAB. CO. ACT (ULLCA) (1995), reprinted in 25 STETSON L. REV. 463(1995).

5. That the existing state statutes have taken approaches that differ from those ofULLCA is an understatement. See, e.g., DEL. CODE ANN. tit. 6, § 18-1101(c) (1993) (tothe extent that there are fiduciary duties at law or equity, they can be restricted byagreement). By agreement, the LLC can indemnify “any member or manager or otherperson from and against any and all claims and demands whatsoever.” Id. § 18-108. Fora brief survey of the statutes, see S. Mark Curwin, Note, Fiduciary Duty and the Minne-sota Limited Liability Company: Sufficient Protection of Member Interests?, 19 WM.MITCHELL L. REV. 989, 1004–15 (1993). An obvious problem with the Delaware statute isthat it does not explain how law or equity would impose a fiduciary duty in the firstplace; it merely states that Delaware recognizes fiduciary duties. Id. at 1007. Agency lawwould still apply to the extent that a person were an agent, see, e.g., RESTATEMENT (SEC-OND) OF AGENCY §§ 379(1), 387 (1957), and ULLCA does state expressly that “each mem-ber is an agent of the limited liability company for purpose of its business.” ULLCA §

missioners on Uniform State Laws (NCCUSL) has recently put thefinishing touches on its Uniform Limited Liability Company Act(ULLCA).4 The influence of uniform statutes suggests that ULLCAis our best chance to develop any degree of uniformity;5 it therefore

1995] Fiduciary Duties Under ULLCA 419

301(a)(1). But this duty is owed to the LLC, not to fellow members. Therefore, underwhat authority could a duty, under agency principles or otherwise, be imposed in favorof other owners? ULLCA § 409(a) refers to the duties owed to both the LLC and itsmembers, but merely to define the only such duties owed and to exclude all others. Seeinfra notes 73 & 74 and accompanying text. Given the position that I take on the fidu-ciary provisions of ULLCA, see infra at Part III(C)(4), and given my general view onfiduciary duties, see Claire Moore Dickerson, From Behind the Looking Glass: GoodFaith, Fiduciary Duty & Permitted Harm, 22 FLA. ST. U.L. REV. 955 (1995), I believethat the duties should exist.

6. See infra Part II(A).7. See, e.g., Keatinge et al., supra note 3, at 391.8. See UNIF. PARTNERSHIP ACT (1994) (RUPA), 6 U.L.A. 280 (Supp. 1995).

NCCUSL's Revised Partnership Act is titled the “Uniform Partnership Act (1994),” but iscommonly referred to as the “Revised Uniform Partnership Act” to avoid confusion withthe original Uniform Partnership Act of 1914. This Article will follow this conventionand cite the Revised Act as “RUPA” and the original Act as “UPA.”

9. Compare RUPA § 404 with ULLCA § 409. See generally infra notes 66 & 72.10. I believe that the standard of performance in RUPA is too low for the partner-

ship context. See infra note 85 and accompanying text. Nevertheless, for our purposeshere, we need only recognize that the NCCUSL drafters intend to transfer to LLCs thestandard previously adopted by NCCUSL for partnerships.

deserves close attention.All drafters of LLC statutes, including NCCUSL, necessarily are

experimenting; here we have the privilege of considering fundamen-tal problems without being directly bound by history. The best expe-rience available to us is by analogy to other business forms, but wemust remember that the LLC is radically different and has no past.The LLC is fundamentally different, as I discuss below,6 because itis an unincorporated entity that cannot be formed by inadvertence,that provides limited liability for its owners without concern for theextent of their involvement in management, and that can obtainpartnership status for federal tax purposes. The first two character-istics are similar to those of a close corporation. Because most LLCshave few members, the close corporation rather than the publicly-held version is the proper point of comparison.7 The last characteris-tic, albeit a tax consideration, is that of a partnership.

Although the LLC is a hybrid, as discussed in Parts II (A) and(B), ULLCA has adopted the Revised Uniform Partnership Act's(RUPA)8 handling of fiduciary duty,9 with the important addition ofa trigger that eliminates the duty of any owner who is not also offi-cially a manager.10 While I object to the exclusion from liability of anowner who is functionally but not officially a manager, my disagree-ment with ULLCA goes to more than technical glitches. I am par-


ticularly concerned by the owners' ability, under ULLCA, to opt outof fiduciary duties (Part II(C)). Part III(A) of this Article describesthe pre-RUPA and pre-ULLCA treatment of fiduciary duty of ownersfor both branches of the LLC's ancestors: the close corporation andthe partnership. It shows that judge-made law balances the actor-owner's control and conflict against the resultant harm that societywill permit the actor-owner to inflict on the co-owners who lack con-trol. Part III(B) of this Article discusses the evolution of limitedliability, and how increased limitation of liability through the cre-ation of LLCs, especially given the potential for opting out of fidu-ciary duties, has disturbed this delicate equilibrium.

Finally, Part III(C) suggests that since the owner of an LLC willremain sheltered from liability to third parties, the balance can bereintroduced by presuming mandatory standard of performancedetermined by the type of business form in question. I discuss anddefend the need for a standard of performance and the reason for amandatory standard. The analysis refines the choice of standard byrecognizing the control and conflict of the actor-owner and the harmpermitted to be inflicted on the co-owners. This permitted-harmanalysis is then applied to the LLC: all other factors being equal, thestandard applied to members of the LLC will presumptively behigher than for shareholders, but lower than for partners. The stan-dard will be higher if the actor-owner has both control and conflict ofinterest, especially if the co-owners are particularly vulnerable toabuse. It will be lowered if the actor-owner has little control or con-flict and the co-owners are not particularly susceptible to harm fromthe actor-owner.

The purpose of this Article, then, is to show how this permitted-harm system avoids a danger inherent in ULLCA. The businessform authorized by ULLCA as currently drafted permits even amanaging owner to have only minimal personal responsibility. Be-cause this is extremely attractive to these owners, the LLC may wellsurpass the partnership and the close corporation as the preferredform of business organization, materially reducing the ethicalchecks on owners, including owner-managers, of businesses in thiscountry. Under the permitted-harm system, ULLCA would continueto allow an LLC's owners, including managing owners, to limit theirpersonal liability to third parties, but it would no longer permitthem to reduce, to a good faith standard, their duty of loyalty to co-owners. The LLC would be functionally, as well as structurally, a


11. Certain LLC statutes do attempt to detail the extent of fiduciary duties, al-though their interpretation may be less clear. Other types of statutes more openly sup-port the opting out concept of the contractarian scholars. In essence, this concept offersto the parties the option of agreeing by contract on the appropriate standard for perfor-mance. For a recent analysis, see Curwin, supra note 5. It has even been suggested thatthe indemnification provisions of certain statutes eliminate fiduciary duties. Id. at 1013.Assuming that some fiduciary duty would be applied by common law, see, e.g., infra PartII(B)(1), discussing evolution of fiduciary duties in corporate law, this proposition is tooaggressive a derogation from common law for implied modification.

12. ULLCA §§ 103(b)(4), 409(d); see infra notes 72–73 and accompanying text.13. The corporation as a “nexus of contracts” is a concept commonly used by the

contractarians. See, e.g., Frank H. Easterbrook & Daniel R. Fischel, The Corporate Con-tract, 89 COLUM. L. REV. 1416, 1426 (1989) (citing Michael C. Jensen & William H.Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and OwnershipStructure, 3 J. FIN. ECON. 305, 311 (1976)). Whether or not this theory is appropriate forcorporations, it has relevance for the general partnership, whose form is substantially asagreed to by the partners. ALLAN R. BROMBERG & LARRY E. RIBSTEIN, PARTNERSHIP §6.07 (1991); CLAIRE MOORE DICKERSON, PARTNERSHIP LAW ADVISER § 5.1, at 136 (1991).As to the applicability of the contractarian analysis to fiduciary duties in the context ofcorporate law, see Butler & Ribstein, supra note 1, and in the context of evolving part-nership law, see Robert W. Hillman, Private Ordering Within Partnerships, 41 U. MIAMI

L. REV. 425, 454–61 (1987); Larry E. Ribstein, The Revised Uniform Partnership Act: NotReady for Prime Time, 49 BUS. LAW. 45, 59 (1993); see generally infra Part II(B)(2).

14. In the context of corporations, see Victor Brudney, Corporate Governance, Agen-cy Costs, and the Rhetoric of Contract, 85 COLUM. L. REV. 1403 (1985) (demanding a highstandard); see also Coffee, supra note 2, at 1618. For an anti-contractarian discussion of

true hybrid of the partnership and the corporation.

II. FIDUCIARY DUTIES AMONG OWNERS WHEN THEBUSINESS FORM IS PURELY A CREATURE OF STATUTE

LLCs are creatures of statute. Consequently, to the extent thatthe statutes describe the extent of fiduciary duties, they control.11

ULLCA does describe fiduciary duty, but permits the parties to de-fine it further, subject to a mandatory threshold of good faith.12 Thequestions are whether this is the correct route, and whether it hasbeen constructed properly.

In the abstract, certain theorists approve the ability of partiesto opt out of fiduciary duties: the contractarians believe in the free-dom of contract and therefore that parties should generally have thefreedom to determine the terms of the various business forms.13

Their preferred statutory definition of fiduciary duties would allowfor maximum opting-out. The anti-contractarians believe that thefiduciary duty ought to be a mandatory standard, and some wantthe mandatory standard to be high.14 The drafters of ULLCA, avoid-


fiduciary duty in partnership law, see Claire Moore Dickerson, Is It Appropriate to Ap-propriate Corporate Concepts: Fiduciary Duties and the Revised Uniform Partnership Act,64 U. COLO. L. REV. 111 (1993) [hereinafter Dickerson, RUPA Fiduciary Duties];Dickerson, supra note 5; Allan W. Vestal, Fundamental Contractarian Error in the Re-vised Uniform Partnership Act of 1992, 73 B.U. L. REV. 522 (1993).

15. See infra Part II(C).16. See, e.g., Thomas E. Geu, Understanding the Limited Liability Company: A

Basic Comparative Primer (Part One), 37 S.D. L. REV. 44 (1992); Keatinge et al., supranote 3, at 379; Curwin, supra note 5. Arguably, the LLC is even more like a limitedpartnership. Since Frigidaire Sales Corp. v. Union Properties, Inc., 562 P.2d 244 (Wash.1977), decided under the Uniform Limited Partnership Act (ULPA), and especially undervariants of the Revised Uniform Limited Partnership Act (RULPA) that expressly permita limited partner not only to hold the title of shareholder, director or officer of a corpo-rate general partner, but also to act as such, the limited partner has little worry aboutlosing the protection of limited liability. See, e.g., DEL. CODE ANN. tit. 6, § 17-303 (1993).However, to those of us who grew up under ULPA and have watched the changesbrought about by RULPA, the limited partnership is itself an evolving hybrid, and thusan insecure anchor for purposes of comparison.

ing any ideological camp, have recommended composite guidelines:when the LLC arguably looks and acts like a partnership, theapplicable fiduciary duty should be the uniform statutes' part-nership-law standard, but when the LLC is more like a close corpo-ration, the level of fiduciary duty applied to shareholders of such acorporation would apply.15

ULLCA is unsatisfactory in at least two ways. First, it is notsupported by a clear understanding of why the LLC is considered ahybrid of the partnership and corporate forms. Second, it does notreflect a full analysis of the standards of performance currently ap-plied to owners of a partnership versus those of a close corporation.We must also consider the limitations of the traditional standardswhen applied to a hybrid business form that is neither a partnershipnor a corporation but, rather, roams broadly on the spectrum be-tween those two.

A. The LLC as a Statutory Hybrid of the Partnership andCorporate Forms

Commentators are happily confirming that the LLC is a hybridof the partnership and corporate forms. They emphasize that theLLC is like a corporation because the statutes allow the owners toprotect themselves from unlimited liability and to centralize man-agement.16 Formation of an LLC, like that of a corporation, requiresformal filing with the applicable state authorities. On the other


17. Keatinge et al., supra note 3, at 385 (describing how the LLC is not bound tocorporation finance and management restrictions); Keatinge et al., supra note 3, at400–01 (describing how management authority is subject to agreement by the parties).

18. See, e.g., Keatinge et al., supra note 3, at 384; Geu, supra note 16, at 45 (refer-ring to the impact of the Internal Revenue Service's Rev. Rul. 88-76, 1988-2 C.B. 360).

19. Subject, however, to the understanding that, as discussed below, tax charac-teristics can define the particulars of the business form.

20. Uniform Partnership Act (UPA) § 6(2) stipulates that the terms of the UPAgovern unless the applicable limited partnership statute is inconsistent. See RULPA §1105. RUPA § 202(b) is the successor to UPA § 6(1); however, there is no RUPA ana-logue to UPA § 6(2). If a limited partnership fails to satisfy the substantial-compliancerequirement for formation under RULPA § 201(b), it will be a general partnership solong as it satisfies the independent criteria for formation of such a partnership. PeerlessMills, Inc. v. American Tel. & Tel. Co., 527 F.2d 445, 449 (2d Cir. 1975) (decided underthe predecessor to RULPA); In re Westover Hills Ltd., 46 B.R. 300, 304 (Bankr. D. Wyo.1985) (decided under RULPA: noncompliance with RULPA filing requirements resultsonly in nonformation of limited partnership, not necessarily in the formation of a generalpartnership); see DICKERSON, supra note 13, at 49 n.58.

21. ULLCA § 201: “A limited liability company is a legal entity, distinct from itsmembers.” ULLCA § 303 provides for limited liability of members and managers:

LIABILITY OF MEMBERS AND MANAGERS.(a) Except as otherwise provided in subsection (c), the debts,

obligations, and liabilities of a limited liability company, whether aris-

hand, the LLC as a business form is like a partnership because itsstructure allows and even encourages owner-management, and be-cause the general flavor of the LLC statutes encourages the partiesto tailor the business form.17 It would, however, be disingenuous tolimit our discussion of the LLCs' partnership characteristics to thepossibility of owner-management and to the possibility of contrac-tual flexibility. What has driven the LLC engine is not a need for anew business form, but rather the federal taxation regime: the HolyGrail was limited liability for all owners, combined with federaltaxation as a partnership.18

When we discuss the LLC as a hybrid we should more properlyview the LLC to be predominately corporate as a business form, andto be predominately partnership from a tax perspective.19 The filingrequirement on the business-law side is essentially neutral, al-though supporting the corporate side. Filing as a prerequisite to for-mation is well-known for corporations, but exists also for limitedpartnerships, and has not prevented limited partnerships from be-ing considered a form of partnership.20 To this extent, the LLC ispassively in the corporate camp.

In contrast, the limited liability of the LLC's owners is emphat-ically a corporate characteristic.21 Not only is it non-existent for gen-


ing in contract, tort, or otherwise, are solely debts, obligations, andliabilities of the company. A member or manager is not personallyliable for a debt, obligation, or liability, of the company solely by rea-son of being or acting as a member or manager. . . . .

(c) All or specified members of a limited liability company areliable in their capacity as members for all or specified debts, obliga-tions, or liabilities of the company if:

(1) a provision to that effect is contained in the articles oforganization; and

(2) a member so liable has consented in writing to theadoption of the provision or to be bound by the provision.

Id.22. In a general partnership, the liability of the ultimate owners can be limited by

interjecting a corporation as the general partner — although the corporate general part-ner itself is fully liable. In a limited partnership, the use of the corporate general part-ner is well-known; while the ultimate owners are substantially shielded from personalliability, technically the general partner itself, i.e. the corporation, has unlimited per-sonal liability. See infra notes 138–40 and accompanying text.

23. For an example of how owner-management is part of the partnership structure,see UPA § 18 (e), (h) and RUPA § 401 (f), (j).

24. There is even statutory recognition of owner-management in corporations. See,e.g., DEL. CODE ANN. tit. 8, §§ 341–356 (1991); N.Y. BUS. CORP. LAW § 620(b) (McKinney1986).

25. Large partnerships have traditionally had executive committees, made up offewer than all the partners, to which management authority has been delegated. For adescription of the extensive authority granted to a national law firm's executive commit-tee, see, e.g., Day v. Avery, 548 F.2d 1018, 1020 (D.C. Cir. 1976), cert. denied, 431 U.S.908 (1977). Whether a particular delegation amounts to centralized management for fed-eral tax purposes is a topic discussed infra at note 28, but it represents centralized man-agement in the sense that even major policy decisions are made by a body that issmaller than a committee of the whole.

eral partnerships, but limited partnerships must have at least onepartner with unlimited personal liability.22 The LLC is but the laststep in eliminating the characteristic of limited liability as a purelycorporate characteristic, but it nevertheless is a corporate charac-teristic for purposes of analyzing a business form in the context ofhistorical expectations.

Just as the filing requirement is essentially neutral, the nomi-nally partnership characteristic of owner-management also is basi-cally neutral.23 Particularly in close corporations, there is a longhistory of owner-managers. Indeed, the concept is so well estab-lished that a separate jurisprudence for owner-managed corpora-tions has evolved.24 Another neutral requirement is the nominallycorporate characteristic of centralized management, which is well-represented especially in larger partnerships.25


26. BROMBERG & RIBSTEIN, supra note 13, § 2.01, at 2:1; DICKERSON, supra note13, § 2.1, at 25; accord Runo v. Rothschild, 189 N.W. 183, 184 (Mich. 1922). The resultappears unchanged by RUPA § 202. See also infra note 66.

27. Although the operating agreement is optional, see ULLCA § 103(a), “the exis-tence of a limited liability company begins when the articles of organization are filed.”ULLCA § 202(b). The articles of organization are defined in ULLCA § 203, and ULLCA§ 202(a) requires that they be filed in an official office. The statute suggests the Secre-tary of State's office.

28. A limited partnership must fail two of the four corporate characteristics of con-tinuity of life, centralized management, liability for business debts limited to the prop-erty of the business, and free transferability of interests. Treas. Reg. § 301.7701-2(a)(1)–(3) (as amended in 1993).

With a lingering doubt about the application of the regulation to a limited part-nership under RULPA (1985) as distinguished from the 1976 version, Treas. Reg. §§301.7701-2(a)(5), -2(b)(3) (as amended in 1993), a RULPA partnership appears to lackcontinuity of life by definition.

Similarly, the present version of the Treasury Regulation states that limitedpartnerships “subject to a statute corresponding to the Uniform Limited Partnership Actgenerally do not have centralized management.” Treas. Reg. § 301.7701-2(c)(4) (asamended in 1993). To ensure protection, the general partners should avoid a represen-tative role, have a substantial ownership interest in the business, and not be subject toremoval by the unilateral vote of the limited partners. Larson v. Commissioner, 66 T.C.159, 176–79 (1976), acq. 1979-1 C.B.1. The IRS will consider ruling that there is no cen-tralized management if the general partners, either in that capacity or as limited part-ners, own at least 20% of the partnership interests, although the actual ruling will de-pend on all the facts and circumstances. Rev. Proc. 89-12, § 4.06, 1989-1 C.B. 798.

A limited partnership subject to the Uniform Limited Partnership Act is alsopresumed to lack the characteristic of limited liability. Treas. Reg. § 301.7701-2(d)(1) (asamended in 1993). This presumption is overcome only when the corporate “general part-ner has no substantial assets [other than his interest in the partnership] . . . and ismerely a `dummy' acting as the agent of the limited partners.” Larson, 66 T.C. at179–81; see Rev. Proc. 89-12, § 4.07, 1989-1 C.B. 798; Zuckman v. United States, 524F.2d 729, 741 (Ct. Cl. 1975).

The remaining characteristic, free transferability of ownership interests, is easierfor a limited partnership to satisfy. If the interests can be transferred without causing

Only a partnership can be created without any formality —indeed, inadvertently, without the subjective intention to create thatbusiness organization.26 Even if the filing requirement is relativelyneutral, the absence of a filing requirement is a peculiarly partner-ship characteristic. An LLC under ULLCA section 202 cannot becreated by inadvertence, since it is formed only upon filing of arti-cles of organization with the appropriate state authorities.27 Finally,treatment as a tax-conduit for federal tax purposes remains a part-nership characteristic. Under current federal tax law, limitedpartnerships are treated as tax conduits presumptively, but eventhey can fail that categorization if they do not look and act suffi-ciently like a general partnership.28 Indeed, the Internal Revenue


dissolution as in Zuckman or for general partners under RUPA § 801, and if the inter-ests of the limited partners can be fully transferred subject only to a general partner'sconsent that is not to be unreasonably withheld, then there is free transferability.Larson, 66 T.C. at 183; Treas. Reg. § 301.7701-2(e) (as amended in 1993). And if sub-stantially all the interests are freely transferable, then the characteristic has been fullysatisfied. Treas. Reg. § 301.7701-2(e)(1) (as amended in 1993). But see Zuckman, 524F.2d at 742 n.14 (holding that 61% of the ownership interest is insufficient to satisfy thesubstantiality requirement); see generally DICKERSON, supra note 13, § 6.2.2.1, at 206–17.

29. Notice 95-14, 1995-14 I.R.B. 7.30. A corporation for which a valid election is made to be treated as an S corpora-

tion is treated substantially as a tax conduit. I.R.C. § 1366 (1988 & Supp. V 1993). How-ever, an S corporation has limitations on the flexibility of allocation of income and de-ductions. Compare id. § 1366 (describing treatment of S corporations) with Treas. Reg. §1.704-1(b) (as amended in 1994) (describing treatment of partnerships). Certain distribu-tions by S corporations are taxed to the shareholders even when the shareholders havean adjusted basis in their ownership shares. Compare I.R.C. § 1368 (1988) (describingtreatment of S corporations) with I.R.C. § 731 (1988 & Supp. V 1993) (describing treat-ment of partnerships). Moreover, a corporation is ineligible for S corporation status if,inter alia, it owns more than 80% of another corporation, if it has a corporate sharehold-er, or a shareholder that is a non-resident alien. I.R.C. § 1361(b) (1988 & Supp. V 1993).One of the major limitations on the availability of S corporation status is the require-ment that there be no more than 35 shareholders. I.R.C. § 1361(b)(1)(A). However, thisrestriction has become much less important since the Service issued Rev. Rul. 94-43,1994-27 I.R.B. 8 (determining that any number of valid S corporations with differentshareholders can form a partnership to operate a single business).

31. See Keatinge et al., supra note 3, at 380: “The LLC . . . combines the tax ad-vantages of a partnership with limited liability for all members . . . .” Id.

32. Id.33. A. Ladra Jensen, Is a Partnership Under the Uniform Partnership Act an Ag-

Service and the Treasury Department, too, justify the possibility ofnew regulations for the taxation of unincorporated businesses byreference to recent changes in state partnership statutes that thetax regulations should recognize.29 While certain corporations canapproximate the tax consequences of partnership states by electingtreatment as an S corporation, they are not really treated as part-nerships even for purely tax purposes because certain basic differ-ences remain.30

As a practical matter, owners typically join an LLC becausethey wish to be taxed as though they are partners.31 Some ownersalso wish to limit their liability while engaging in management ofthe business.32 On a more abstract level, the importance of being atax conduit is that it emphasizes the aggregate aspect of the rela-tionship among the owners. In partnerships, the concept that thebusiness is an aggregation of its owners instead of a separate entityhas particular importance in the operation of the business.33 It is


gregate or an Entity?, 16 VAND. L. REV. 377, 379 n.11 (1963).34. See, e.g., Robert J. Rosenberg, Partnership Reorganization Under the Bank-

ruptcy Reform Act: Filling in the Interstices, 56 N.Y.U. L. REV. 1173, 1173–75 (1981).35. Limited partners in limited partnerships and members of LLCs, even if treated

as partners for tax purposes, can have limited liability. See, e.g., Keatinge et al., supranote 3, at 385, 442–46.

36. I.R.C. § 704 (1988 & Supp. V 1993); I.R.C. § 706 (1988). This reality would notbe changed by the adoption of the proposed regulations referred to in the text accompa-nying note 29, supra.

37. Treas. Reg. § 301.7701-2 (as amended in 1993). As to the characterization of anunincorporated business as a partnership for tax purposes, the principal differences be-tween a partnership, including a limited partnership, see supra note 28, and an LLC arein the application of the four criteria, at least two of which must be lacking for the un-incorporated business to be treated as a partnership for tax purposes. I.R.C. § 7701(a)(2)(1988); Treas. Reg. §§ 301.7701-2, -3.

With respect to continuity of life, if a majority in interest must vote in favor ofcontinuation of the business after the withdrawal of any member, then the LLC isdeemed to fail the corporate characteristic of continuity of life. Rev. Rul. 93-6, 1993-1C.B. 229, 230; Rev. Rul. 93-91, 1993-2 C.B. 316, 317.

If there are appointed managers, the LLC will be found to satisfy the corporatecharacteristic of centralized management, regardless of the equity interests of those man-agers. See, e.g., Rev. Rul. 94-6, 1994-1 C.B. 314; Rev. Rul. 94-5, 1994-1 C.B. 312; Rev.Rul. 93-92, 1993-2 C.B. 318; see also Rev. Rul. 93-38, 1993-1 C.B. 233, 235 (situation 2);Rev. Rul. 93-6, 1993-1 C.B. 229; Rev. Rul. 93-5, 1993-1 C.B. 227.

An LLC might wish to fail the corporate characteristic of limited liability, if, forexample, it would otherwise lack only one characteristic but wishes to be treated as apartnership for tax purposes. The Service has not yet ruled when and if the LLC could

this aggregate theory that explains, for example, why owners shouldhave unlimited personal liability for the obligations incurred by thebusiness.34 However, treatment as a partnership by the tax authori-ties has no direct consequences outside tax law. Such treatmentdoes not, for example, mean that the owners will in fact have unlim-ited personal liability for the obligations of the business.35 It doesnot mean unlimited personal liability even in the tax context: al-though the tax liability of LLC members is defined by the income ofthe business, an owner taxed as a partner is not liable to the govern-ment for taxes owed and unpaid by a co-owner.36

So how can this tax characteristic prevent an LLC from beingtreated as a corporation for non-tax purposes? The answer is in therequirements that an unincorporated business must satisfy to betaxed as a partnership. Under current federal tax law, the LLC, asan organization that provides limited liability for its owners, cannotsatisfy more than one of the following three criteria if it is to avoidbeing taxed as a corporation: centralized management, continuity oflife, and free transferability of ownership.37 Because the Treasury is


be considered to lack that characteristic. However, by analogy to the limited partnership,this option should be available if a member can be made liable, has substantial assets,and is not merely a “dummy” for the other, non-liable members. Zuckman v. UnitedStates, 524 F.2d 729, 740–41 (Ct. Cl. 1975); Larson v. Commissioner, 66 T.C. 159,179–81 (1976), acq. 1979-1 C.B. 1; Treas. Reg. § 301.7701-2(d)(2) (as amended in 1993);Rev. Proc. 89-12, § 4.07 1989-1 C.B. 798.

Regarding free transferability of interests, the characteristic is lacking if at leasta majority in interest of the LLC's members must vote in favor of the admission of anew member. Rev. Rul. 93-92, 1993-2 C.B. 318; Rev. Rul. 93-91, 1993-2 C.B. 316. Theserulings do not speak of what happens if there a substantial interest, but less than amajority, is the required vote.

38. Notice 95-14, 1995-14 I.R.B. 7.39. Id.

considering proposing new regulations that would presume part-nership status for any unincorporated business, subject to contraryelection by the business,38 the LLC of the future may not feel anypressure to avoid those last three criteria. However, the basis forTreasury's contemplation of a new regime is the perception thatpartnership, outside of the tax arena, no longer prevents a partner-ship from satisfying those criteria.39 In other words, at least accord-ing to Treasury, an LLC still contains partnership characteristics.We will look at these concepts again when we consider in Part IIIhow the LLC characteristics influence the need for fiduciary duty.For our present purpose, the status of the LLC as a partnership forfederal tax treatment leans the LLC toward the partnership end ofthe business-form spectrum, because the LLC must be like a tradi-tional partnership in at least two of four fundamental ways, and willin the future continue to be similar to the then-current form of part-nership.

We are now prepared to pull together the irreducible differencesbetween partnerships and corporations, and to apply them to LLCs.Corporations, like LLCs, offer limited liability to owners, includingowners who also are managers, and only partnerships, unlike theLLC, can be created without formality, and even without subjectiveintention. So far, the LLC is more like a corporation than a partner-ship. The remaining functional characteristic of the LLC is one that,in contrast to limited liability and impossibility of inadvertent for-mation, pushes the LLC in the direction of partnerships — only thepartnership is truly a conduit for federal tax purposes: no incorpo-rated business form is a tax conduit to the same degree.


40. 164 N.E. 545 (N.Y. 1928) (Cardozo, J.). The relationship in Meinhard was not atrue partnership and may not even have been a true joint venture. Nevertheless, thecase is understood to define fiduciary duty in the partnership context. For example, it isthe principal case in a prominent casebook's section entitled “The Partner's Duty of Loy-alty.” WILLIAM L. CARY & MELVIN A. EISENBERG, CORPORATIONS 56 (6th ed. 1988).

41. Meinhard, 164 N.E. at 546.42. In Meinhard, Judge Cardozo insisted on “uncompromising rigidity,” id., as he

had in the agency context. Wendt v. Fischer, 154 N.E. 303, 305 (N.Y. 1926). His viewwas arguably substantially similar in the corporate context, although there is indicationthat he would have found that full disclosure would satisfy the obligation. Globe WoolenCo. v. Utica Gas & Elec. Co., 121 N.E. 378 (N.Y. 1918) (addressing interested-directorliability). Indeed, Globe Woolen represents an effort by Judge Cardozo to apply someflexibility in the context of the fiduciary duty of interested directors. Dickerson, RUPAFiduciary Duties, supra note 14, at 126. Nevertheless, in the latter two cases, JudgeCardozo cites approvingly Munson v. Syracuse, Geneva & Corning R.R., 8 N.E. 355 (N.Y.1886), in which, upon finding a breach of duty, the New York Court of Appeals refusedto inquire about the fairness of the transaction. Id. at 358. In Globe Woolen, JudgeCardozo stretched to void the offending contract on the basis of breached fiduciary duty:he could have voided the contract on contract-law principles, given that the purchaser'ssudden and dramatic increase in requirements was evidence of a lack of good faith. SeeGlobe Woolen, 121 N.E. at 378; Deborah A. DeMott, Beyond Metaphor: An Analysis ofFiduciary Obligation, 1988 DUKE L.J. 879, 899.

43. UPA § 21. Partner Accountable as a Fiduciary.(1) Every partner must account to the partnership for any benefit, and hold astrustee for it any profits derived by him without the consent of the other part-ners from any transaction connected with the formation, conduct, or liquidationof the partnership or from any use by him of the property.

UPA § 21.44. That the language is understood to create a general fiduciary duty, see general-

B. Partnership Versus Corporation-Law PerformanceStandards, Currently

1. Case Law

Traditional case law contains two lines of analysis, one applica-ble to the partnership and the other to the close corporation.

The seminal partnership case is Meinhard v. Salmon.40 It con-tains Judge Cardozo's exuberant description of fiduciary duty as the“punctilio of an honor the most sensitive.”41 He also condemned anyreduction of the standard.42 The standard of utmost good faith inpartnership law, and the categoric insufficiency of simple arm's-length good faith, is considered to reside in Uniform Partnership Act(UPA) section 21.43 That section is cursory and its express languagefocuses only on misappropriation of benefits, but the gloss providedby Meinhard and its case-law progeny is now firmly imbedded in theeighty-year-old Uniform Partnership Act.4 4 Any sub


ly Jennison v. Bierer, 601 F. Supp. 1167, 1177 (D. Vt. 1984) (relations between partnershighly fiduciary; trustees in all dealings with partnership property); Cude v. Couch, 588S.W.2d 554, 555 (Tenn. 1979) (holding that a duty exists in all matters relating to part-nership); BROMBERG & RIBSTEIN, supra note 13, § 6.07, at 6:72; DICKERSON, supra note13, § 13.2, at 427.

45. However, statutes do speak of duties of directors. See, e.g., DEL. CODE ANN. tit.8, §§ 141(e), 102(b)(7) (1991); N.Y. BUS. CORP. LAW §§ 717, 402(b) (McKinney 1986 &Supp. 1995).

46. 328 N.E.2d 505 (Mass. 1975).47. With respect to close corporations, see Wilkes v. Springside Nursing Home,

Inc., 353 N.E.2d 657, 663 (Mass. 1976). This is a characteristic familiar to partnerships.The ABA subcommittee charged with considering the systematic overhaul of the UPAthat ultimately led to RUPA expressly recognized that partners have a dual role as bothmanagers and owners. UPA Revision Subcommittee of the Comm. on Partnerships andUnincorporated Business Orgs., Should the Uniform Partnership Act Be Revised?, 43BUS. LAW. 121, 151 (1987).

48. Once the controlling shareholders have been accused of breach of fiduciaryduty, they can nevertheless succeed in their defense if they can bear the burden ofshowing a legitimate business purpose for their actions. By dictum, the shareholders wholack control could then show that the controlling shareholder still has breached a dutybecause the controlling shareholders could have achieved their legitimate business pur-pose in a less harmful manner. Wilkes, 353 N.E.2d at 663. This certainly implies that alegitimate business purpose does not excuse acts that are malicious, as opposed tomerely a reflection of “selfish ownership.” Id.

As to what constitutes a legitimate business purpose, the controlling shareholderis allowed to be concerned with its own personal business, as opposed to the business ofthe corporation. In Smith v. Atlantic Properties, Inc., 422 N.E.2d 798, 803 (Mass. App.Ct. 1981), the controlling shareholder could try to reduce his personal tax liability whennon-controlling shareholders failed to respect the controlling shareholder's suggestions ofa non-malicious solution (the preparation of a plan for repairs and improvements). Id.

stantive change therefore requires statutory intervention, as is dis-cussed below in connection with the fiduciary duties under ULLCA.

As compared with the UPA's view of the owners' fiduciary duty,a more tempered version of the standard applies to shareholders ofclose corporations. Although every corporation is formed in accor-dance with a statute, the corporate statutes do not expressly man-date a fiduciary duty for a corporation's owners: it is case law thathas found the fiduciary duty owed by shareholders.45

While the court in Donahue v. Rodd Electrotype46 ruled that thecontrolling shareholder breached his fiduciary duty to the minority,subsequent cases in the same line expressly recognized theshareholder's right of “selfish ownership.”47 A controlling sharehold-er may act so as to harm the minority if the controlling shareholderhas a legitimate business purpose and lacks a less harmful means ofachieving that legitimate result.48 Nevertheless, the fundamentalduty, owed at least by the controlling shareholder, is a fiduciary


49. Wilkes, 353 N.E.2d at 661; Donahue, 328 N.E.2d at 515; Smith, 422 N.E.2d at801.

50. See Easterbrook & Fischel, supra note 13, at 1426 (citing Jensen & Meckling).For an example of other scholars' disputing of the contractarians' analysis, see, e.g.,Thomas Lee Hazen, The Corporate Persona, Contract (and Market) Failure, and MoralValues, 69 N.C. L. REV. 273 (1991).

51. The contract model allows the parties to seek the economically efficient result.See, e.g., RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW § 2.2, at 23 (4th ed. 1992).

52. See the court's opinion, written by Judge Frank H. Easterbrook, and the dis-sent, written by Judge Richard A. Posner, in Jordan v. Duff & Phelps, Inc., 815 F.2d429 (7th Cir. 1987), cert. dismissed, 485 U.S. 90 (1988). Both are well-knowncontractarians and former colleagues on the faculty of the University of Chicago Schoolof Law. Judge Easterbrook found that the fiduciary duties had not been waived, but bydictum noted that they could have been waived by a proper agreement. Id. Judge Posnerfound a contract that would serve to waive fiduciary duty. Id. (Posner, J., dissenting).

Judge Easterbrook has also specifically confirmed that the fiduciary duty may bewaived down to an irreducible good faith level. Easterbrook & Fischel, supra note 13, at1422; see generally Dickerson, RUPA Fiduciary Duties, supra note 14, at 133.

53. Even Jordan is a close corporation case: there were only 41 shareholders. 815F.2d at 432. Of course, this does not mean that the shareholders of a publicly-held cor-poration owe duties to each other. See, e.g., Securities Exchange Act of 1934, § 10(b), 15U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5.

duty.49

2. Scholarly Commentary

The contractarians have defined the terrain concerning fiducia-ry duties in business corporations, as a “nexus of contracts.”50 Fromthis assumption, the contractarians conclude that the owners, asparties to the contract, can opt out of obligations otherwise arisingout of the relationship as shareholders.51 Specifically, the share-holders can agree to lower the standard of performance otherwiseapplicable among them, down to some level of good faith.52 If theexisting standard did allow shareholders to be purely selfish in theirrelationships among themselves, there would be no standard abovethe mandatory good faith threshold and the issue of opting out offiduciary duties would never arise. Therefore, the contractarians'discussion of shareholders' capacity to opt out of fiduciary dutiesincludes a recognition that, at least in the close corporation contextof Donahue and its ilk,53 shareholders can be subjected to aheightened standard of performance.

As noted, the contractarians' concession that a heightened stan-dard exists is part of their assumption that the parties can opt out of


54. In Jordan, both Judge Easterbrook (for the court) and dissenting Judge Posneragreed that the parties could opt out of the fiduciary duty. 815 F.2d at 436, 446; seesupra note 49. As is evident from the fact that one contractarian was writing for thecourt and the other was dissenting, the judges did not agree as to whether the partieshad in fact opted out. Much has been made of this disagreement between titans. See,e.g., Coffee, supra note 2, at 1680–81; DeMott, supra note 42, at 884–85 (describing thecharacterization of a fiduciary duty as “the court's guess about what the parties wouldhave agreed to” as “unprecedented”).

55. The most famous articulation of the concession theory was by Chief JusticeMarshall's statement that a “corporation is an artificial being, invisible, intangible andexisting only in contemplation of law.” Trustees of Dartmouth College v. Woodward, 17U.S. (4 Wheat.) 518, 636 (1819). See generally William W. Bratton, Jr., The New Eco-nomic Theory of the Firm: Critical Perspectives from History, 41 STAN. L. REV. 1471,1484, 1504–05 (1989).

56. See ROBERT W. HAMILTON, CASES & MATERIALS ON CORPORATIONS 12-14 (4th ed.1990); Eric W. Orts, Beyond Shareholders: Interpreting Corporate Constituency Statutes,61 GEO. WASH. L. REV. 14, 68–69 (1992).

Because LLCs, like corporations, can be formed only by filing, the concession the-ory would also apply to LLCs. As to the importance of a filing requirement, see general-ly Larry E. Ribstein, Limited Liability and Theories of the Corporation, 50 MD. L. REV.80, 86 (1991).

57. Subject to the rights of third parties, since these cannot be waived withouttheir consent.

58. See, e.g., Ribstein, supra note 56, at 83 (arguing that there is no reason forlimited liability to be considered a state-conferred privilege rather than a product ofprivate ordering). This contractarian concedes that “[u]nderstanding the contractual na-ture of limited liability is the last important step toward full recognition of the contrac-tual nature of the corporation.” Id. at 130. This concession is itself an admission thatcorporate-style limited liability, effective as against the world, cannot be created byagreement between two parties.

this standard.54 This sense of certainty on the part of thecontractarians has dominated the discussion, leaving the non-contractarians in a difficult position. The non-contractarians whobelieve that the heightened standard is mandatory must challengean orthodoxy either by disagreeing that the corporation is a nexus ofcontracts, or by conceding that the contract-law approach is correctwhile disputing that the standards are optional. The first approachreincarnates the old concession theory of corporations.55 The conces-sion theory suggests that the government can impose on corpora-tions whatever limitations the state wants because the state hascreated the corporation.56 One of these limitations can be mandatoryfiduciary duties. Others, including those who believe that fiduciaryduty should be optional, may be willing to consider non-fiduciarycorporate norms subject to agreement among the shareholders,57 andtherefore accept that the state is defining part of the contract.58 If


59. See, e.g., John C. Coffee, Jr., No Exit?: Opting Out, the Contractual Theory ofthe Corporation, and the Special Case of Remedies, 53 BROOKLYN L. REV. 919, 970–73(1988) (discussing the use of form contracts to save the costs of negotiating). The purecontractarians reject any mandatory fiduciary obligations: any such obligations should beincluded in corporate law only as enabling legislation. See, e.g., Butler & Ribstein, supranote 1, at 67–68.

60. UPA is principally a “default” statute, subject to modification as among the par-ties. BROMBERG & RIBSTEIN, supra note 13, § 6.07, at 6:72; DICKERSON, supra note 13, §5.1, at 136. RUPA § 103(a) provides that RUPA applies only as a default rule except forthose few topics listed in RUPA § 103(b).

61. Case law interpreting UPA has clearly maintained that the partners cannotagree among themselves to unilaterally affect the rights of third parties. See, e.g., Misco-United Supply, Inc. v. Petroleum Corp., 462 F.2d 75, 80 (5th Cir. 1972); Belgian Over-seas Sec. Corp. v. Howell Kessler Co., 450 N.Y.S.2d 493 (App. Div. 1982); B-OK, Inc. v.Storey, 473 P.2d 426, 429 (Wash. 1970). RUPA is more explicit: “[t]he partnership agree-ment may not: . . . restrict the rights of third parties under this [Act].” RUPA §103(b)(9).

62. See, e.g., Hillman, supra note 13.63. Despite the lack of express language, common law has interpreted the statute

to include fiduciary duty. See supra notes 43–45 and accompanying text for a discussionof UPA § 21.

the state's role in mandating fiduciary obligations is viewed as anefficient means of short-circuiting negotiations by imposing formcontracts, the analysis has a contractarian form.59 At the base, how-ever, the question remains: Why can the state impose this limita-tion? Even if the parties' basic relationship is viewed as contractual,the mandatory obligations exist either because might makes right,or, more gently, because the state can define its own creation.

This same discussion has also been carried over into the sphereof unincorporated businesses. Contractarians have not been able touse all of their contract-law ammunition on partnership-law fidu-ciary duty even though the bulk of the partnership relation is sub-ject to definition by contract.60 The largest category of obligationsthat cannot be modified by agreement among the partners are, pre-dictably, obligations owed to third parties.61 The category that hasno impact on third parties but is still not subject to modification bythe partners under UPA is the fiduciary duty owed by one partner toanother. The reason why the contractarians are restricted to criesabout the illogic of mandatory fiduciary duties in partnership,62 ascontrasted with their cries that mandatory fiduciary duties do notexist in corporations, is that it is in partnership law, not in corpo-rate law, that fiduciary duty has been found enshrined in the stat-ute.63 Therefore, any fundamental change to fiduciary duty as ap-


64. NCCUSL had recently revised the uniform law applicable to limited partner-ships. The 1976 Revised Uniform Limited Partnership Act (RULPA) was substantiallyrevised in 1985. Although RULPA was a clear influence on the drafters of RUPA, see,e.g., the comments of RUPA Reporters in Donald J. Weidner & John W. Larson, The Re-vised Uniform Partnership Act: The Reporters' Overview, 49 BUS. LAW. 1, 7 (1992), it didnot change fiduciary duties. See RULPA § 403(1). For an explanation that UPA appliesto limited partnerships unless the applicable uniform limited partnership statute pro-vides otherwise, see supra note 20.

65. That the impact of RUPA on fiduciary duties was of great importance is reflect-ed in the Reporters' discussion of that topic as a main heading. See Weidner & Larson,supra note 64, at 16. The other major headings of dissolution, partnership property andconversions and mergers are all modifications that flow from RUPA's purposeful effect ofshifting partnership law toward the entity theory. Id. at 3, 28, 38.

66. RUPA § 404 provides that:(a) The only fiduciary duties a partner owes to the partnership

and the other partners are the duty of loyalty and the duty of careset forth in subsections (b) and (c).

(b) A partner's duty of loyalty to the partnership and the otherpartners is limited to the following:

(1) to account to the partnership and hold as trustee . . .any . . . benefit . . . ;

(2) to refrain from dealing with the partnership . . . as . . .a party having an interest adverse to the partnership; and

(3) to refrain from competing with the partnership . . . .(c) A partner's duty of care . . . is limited to refraining from en-

gaging in grossly negligent or reckless conduct, intentional misconduct,or a knowing violation of law.

(d) A partner shall discharge the duties . . . under this [Act] . . .and exercise any rights consistently with the obligation of good faithand fair dealing.

(e) A partner does not violate a duty or obligation under this[Act] . . . merely because the partner's conduct furthers the partner'sown interest.

(f) A partner may lend money to and transact other business withthe partnership, and . . . the rights and obligations of the partner arethe same as those of a person who is not a partner, subject to applica-ble law. . . . .

Id.67. RUPA § 103 provides in pertinent part:(b) The partnership agreement may not: . . .

(3) eliminate the duty of loyalty . . . , but:

plied to partnerships has to be effected by statute.The battle has been fought during NCCUSL's work on the draft

of the Revised Uniform Partnership Act (RUPA), the recently pro-posed revision to the eighty-year-old uniform partnership law.64 Oneof the most significant changes contained in RUPA is the substantialincrease in the parties' ability to opt out of fiduciary duties.65 Gener-ally, RUPA sections 40466 and 10367 permit partners in a general


(i) the partnership agreement may identify specific types orcategories of activities that do not violate the duty of loyalty, ifnot manifestly unreasonable; or(ii) all of the partners . . . may authorize or ratify, after fulldisclosure of all material facts, a specific act or transaction thatotherwise would violate the duty of loyalty;

(4) unreasonably reduce the duty of care . . . ;(5) eliminate the obligation of good faith and fair dealing . . . , but thepartnership agreement may prescribe the standards by which the per-formance of the obligation is to be measured, if the standards are notmanifestly unreasonable; . . . .

Id.68. See generally Weidner & Larson, supra note 64, at 16–28.69. Dickerson, RUPA Fiduciary Duties, supra note 14, at 149–56; Dickerson, supra

note 5. Professor Eisenberg asserts that an "inadvertent" partnership is a "misconcep-tion." WILLIAM L. CARY & MELVIN A. EISENBERG, CASES AND MATERIALS ON CORPORATIONS

39 (7th ed. unabridged 1995). In my view, there is true inadvertence when objectiveintent is at odds with subjective intent. Dickerson, RUPA Fiduciary Duties, supra note14, at 154. In contrast, the courts are reluctant to find the offer that leads to formationof a contract, see, e.g., E.A. FARNSWORTH, CONTRACTS, § 3.10, at 138 (2d ed. 1990), whilea partnership is presumptively found if there is profit sharing. UPA § 7(4); RUPA §202(c). Hence, it is more likely that a partnership than a contract will be formed despitecontrary subjective intent.

70. As of August 1995, three states have adopted a version of RUPA. MONT. CODE

ANN. §§ 35-10-101 to -644 (1994); TEX. REV. CIV. STAT. ANN. art. 6132b (West Supp.1995); WYO. STAT. §§ 17-21-101 to -1003 (1995).

partnership to reduce the Meinhard duty to a level of good faith.68

Elsewhere, I have complained that the general partnership is aninappropriate forum for freedom of contract, because it can beformed by inadvertence, and even against specific subjective in-tent.69 A person can have the unlimited personal liability of a gener-al partner without ever having had the subjective intent to form apartnership. The risk generated by freedom of contract in this areais compounded by the contract-law principle of objective intent. Aperson could be found not only to be a partner without subjectiveintent to do so, but also to have waived any rights to fiduciary pro-tection. Nevertheless, RUPA permits opting out from a significantrange of duties. As of this writing, RUPA has been adopted by onlythree states.70 When the statute has been adopted by a substantialnumber of jurisdictions, the option to eliminate fiduciary duties byagreement among partners moves from the realm of scholarly com-mentary to that of reality.

C. Fiduciary Duty Under the Draft Uniform Limited


71. See supra Part II(A).72. ULLCA § 409 GENERAL STANDARDS OF MEMBER'S AND MANAGER'S

CONDUCT.(a) The only fiduciary duties a member owes to a member-man-

aged limited liability company and its other members are the duty ofloyalty and the duty of care imposed by subsections (b) and (c).

(b) A member's duty of loyalty to a member-managed companyand its other members is limited to the following:

(1) to account to the company and to hold as trustee . . .any . . . benefit . . . ;

(2) to refrain from dealing with the company . . . as . . . aparty having an interest adverse to the company; and

(3) to refrain from competing with the company . . . .(c) A member's duty of care to a member-managed limited com-

pany and its other members . . . is limited to refraining from engag-ing in grossly negligent or reckless conduct, intentional misconduct, ora knowing violation of law.

(d) A member shall discharge the duties . . . and exercise anyrights consistently with the obligation of good faith and fair dealing.

(e) A member of a member-managed company does not violate aduty or obligation under this [Act] . . . merely because the member'sconduct furthers the member's own interest.

(f) A member of a member-managed company may lend money toand transact other business with the company. As to each loan ortransaction, the rights and obligations of the member are the same asthose of a person who is not a member, subject to other applicablelaw.

(h) In a manager-managed company:(1) a member who is not also a manager owes no duties to

the company or to the other members solely by reason of beinga member;

(2) a manager is held to the same standards of conduct pre-scribed for members in subsections (b) through (f);

(3) a member who pursuant to the operating agreementexercises some or all of the rights of a manager in the manage-ment and conduct of the company's business is held to thestandards of conduct in subsections (b) through (f) to the extentthat the member exercises the managerial authority vested in amanager by this [Act]; and

(4) a manager is relieved of liability imposed by law for

Liability Company Act

We have seen that the LLC authorized by ULLCA is located onthe spectrum between partnerships and corporations, relativelycloser to corporations.71 Given that we are dealing with a hybrid, thenext question is how ULLCA handles the members' fiduciary duties:are they more like those of shareholders in a close corporation, ormore like those of partners? Two sections are particularly relevantto issues of fiduciary duty: ULLCA sections 40972 and 103.73 The first


violation of the standards prescribed by subsections (b) through(f) to the extent of the managerial authority delegated to themembers by the operating agreement.

ULLCA § 409.73. ULLCA § 103. EFFECT OF OPERATING AGREEMENT: NONWAIVABLE PRO-

VISIONS.(b) The operating agreement may not:

(2) eliminate the duty of loyalty . . . , but the agreementmay:

(i) identify specific types or categories of activitiesthat do not violate the duty of loyalty, if not manifestlyunreasonable; and

(ii) specify the number or percentage of members ordisinterested managers that may authorize or ratify, afterfull disclosure of all material facts, a specific act or trans-action that otherwise would violate the duty of loyalty;

(3) unreasonably reduce the duty of care . . . ;(4) eliminate the obligation of good faith and fair

dealing . . . , but the operating agreement may determinethe standards by which the performance of the obligationis to be measured, if the standards are not manifestly un-reasonable; . . . .

ULLCA § 103(b).74. ULLCA § 409(a) outlines the standards for a member in a member-managed

LLC; ULLCA § 409(h) treats manager-managed LLC. See supra note 72 for the text ofULLCA § 409(a) and (h).

75. See supra Part II(A).

describes the only fiduciary duties owed by an owner (member) of anLLC. The second provides methods by which the parties can agree toreduce the duties, and describes the floor below which those dutiescannot be reduced. Section 409 explicitly distinguishes between theduties owed by a member in a “member-managed limited liabilitycompany” and those owed by a member or manager in a “manager-managed limited liability company.”74

Consider that limited liability and the impossibility of formationby inadvertence are the strong corporate characteristics, that thetax treatment is the strong partnership characteristic, and thatowner-management in particular does not pull strongly toward part-nership status.75 A difference in standards should not be determinedby owner-management alone. Nevertheless, this is what the draftershave done by separating section 409(a) liability for member-man-aged LLCs from section 409(h) liability for manager-managed LLCs.Except for its last subsection (h), ULLCA section 409 is virtually


76. Compare ULLCA § 409, supra note 72, with RUPA § 404, supra note 66.77. See ULLCA § 409(e), (f); RUPA § 404.78. ULLCA § 103(b)(2); RUPA § 103(b)(3).79. ULLCA § 103(b)(4); RUPA § 103(b)(5).80. See supra note 72 (discussing ULLCA § 409(h)). The manager could, of course,

be a member. However, in that case, ULLCA § 409(h) stipulates that any liability of themanager is in its capacity as manager, not as a member. Assuming a manager-managedLLC, a person who is a member but not a manager has liability. ULLCA § 409(h)(1). Amanager has the liability of a member in a member-managed LLC. ULLCA § 409(h)(2).

81. See ULLCA § 409(h)(3). The specific language of ULLCA § 409(h)(3) must de-fine what is a manager; otherwise, ULLCA § 409(h)(2) makes it superfluous.

82. The comments to ULLCA § 409 are in the form adopted at NCCUSL's July29–August 5, 1994 annual conference with amendments adopted by its Executive Com-mittee in January, 1995.

identical to RUPA section 404.76 Focusing on a member-managedLLC, ULLCA section 409 expressly provides, as does RUPA section404, that an owner who benefits personally from a transaction inconnection with the entity of which that person is an owner does notnecessarily violate the duty of good faith: the owner can lend moneyor transact other business with its company as though the ownerwere a third party,77 and any inherent conflict is ignored. Further,just as is the case for the section of RUPA bearing the same number,ULLCA section 103 specifies that, although the duty of loyalty can-not be eliminated, the operating agreement can specify categories ofactivities that, by agreement of the parties, do not violate the duty ofloyalty.78 As does RUPA, ULLCA prohibits elimination of the obliga-tion of good faith and fair dealing, but simultaneously permits anagreement among the owners to “determine the standards by whichperformance of the obligation is to be measured.”79

In contrast, if the LLC is not member-managed, but instead ismanager-managed, ULLCA section 409(h) follows a corporate pat-tern, and there is no direct RUPA analogue. Subsection (h) imposesno fiduciary duty on a mere member; it is the manager in a manag-er-managed LLC who has the same duties as any member of amember-managed LLC.80 In addition, to the extent that a memberexercises the functions of a manager under the operating agreement,the member will have the fiduciary duties of a manager.81 Althoughthe draft comments do not explain this subsection,82 the allocation ofresponsibility based on management function is presumably tooclose to classic corporate law to be by accident: normally directorsare responsible for and liable for the management of the corpora-


83. Charlestown Boot & Shoe Co. v. Dunsmore, 60 N.H. 85 (1880) is an old casethat linked liability to management responsibility, and management responsibility to theboard of directors. Modern corporate statutes do the same. See, e.g., DEL. CODE ANN. tit.8, §§ 141(a) (stipulating management by the board); 350 (stating that in a close corpora-tion, an agreement among shareholders to limit the discretion of the board is valid, butto the extent of that limitation, the liability of the directors is removed) (1991).

84. See, e.g., DEL. CODE ANN. tit. 8, § 350 (1991).85. Donahue v. Rodd Electrotype Co., 328 N.E.2d 505 (Mass. 1975); see supra text

accompanying note 49.86. The language of ULLCA § 409(h)(3) stating that a “member functioning as a

manager” under the operating agreement, is not carried over uniformly to other sections.For example, § 801(b)(3) provides that “a member who is also a manager” can cause thedissolution of the LLC in specified circumstances.

87. See, e.g., Duncan Kennedy, Form and Substance in Private Law Adjudication,89 HARV. L. REV. 1685, 1773 (1976).

88. See, e.g., Dickerson, RUPA Fiduciary Duties, supra note 14; Dickerson, supranote 5.

tion.83 Shareholders are personally liable as managers only to theextent that they in fact manage.84 ULLCA in fact goes farther thanthat: apparently, if a member is effective in persuading the manag-ers but does not have express authorization under the operatingagreement to act as a manager, the member has no liability. Thisconcept is formalistic and, to put it mildly, different from the analy-sis of Donahue and its progeny, where controlling shareholders areheld liable whether or not they have the separate designation of anofficial manager.85 Clearly, the manager-owner trigger of theULLCA is imperfect in practice.86

Leaving aside what may be dismissed as a correctable technicalerror, I want to focus on the inadequacy of ULLCA's trigger as amatter of principle. We may not approve either of RUPA's exclusivelist of fiduciary duties because it tends to narrow the scope morethan does a generalized standard,87 or of RUPA's support of optingout by owners. I consider RUPA to represent an unacceptable dilu-tion of mandatory fiduciary duties, because I consider these dutiesto be an important principle of partnership law.88 We may also re-ject, as I do, the idea that owner-management should be a litmustest, let alone the sole test, used to determine the type of fiduciaryduty imposed on owners. Nevertheless, the ULLCA drafters presum-ably feel the owner-manager dichotomy distinguishes corporationsfrom partnerships, and they allocate the owners' fiduciary duty onthat basis. The question is whether either or both of the standardsand the test should be enacted.


III. THE EXTENT OF PERMITTED HARM DETERMINES THEAPPROPRIATE STANDARD OF PERFORMANCE

In discussing the appropriate standard of performance forLLCs, we must consider two questions. In the context of the currenttext of ULLCA, the questions break down as follows: are the articu-lated standards appropriate, and is the trigger mechanism for se-lecting one of those standards appropriate? The questions are inex-tricably linked: if the fundamental standards should be different,that will affect the appropriateness of the trigger. Even if theULLCA trigger based on owner-management is appropriate, itmight not be the proper trigger if ULLCA makes the standards sus-ceptible to opting out by the owners who are managers. It may alsobe more appropriate to have a system of standards that has morethan two default variations.

Before the standards articulated by ULLCA can be analyzedmeaningfully, we have to review their context and consequences. Inthe last section, I stated that the LLC leans toward the corporationend of the partnership-to-corporation spectrum, particularly nearthe close corporation. The LLC resembles a corporation in that itcannot be formed by inadvertence and creates only limited liabilityfor the owners, but it is not purely corporate because it can alsoshare with the partnership form the federal tax status as a conduit.Because the LLC is created by a statute that provides an expressdefinition of fiduciary duty, the applicable statute must control. Itwill control quite literally, because there is little room for interpre-tation. The express language prevents limited liability company lawfrom mimicking the Donahue line's common-law incursion into cor-porate law, while the newness of the statute, as well as its precision,restricts the evolution of a Meinhard-style inventive gloss. Thepossible interpretative leeway is limited to analogies to partnershipand corporate law, on precisely the larger theory already reflectedby the drafters: the effect of ULLCA should be relatively corporate ifthe LLC is like a corporation and vice versa. My disagreement con-cerns how to determine whether and to what extent an LLC isrelatively corporate, and what the impact of that distinction shouldbe.

We cannot avoid a careful review of the basic questions set outearlier. First, are ULLCA's trigger and standards appropriate? I will


89. See supra text accompanying note 21 discussing ULLCA §§ 201, 303. Membersdo have the right to waive the protection of limited liability, something that they wouldpresumably do for tax reasons. ULLCA § 303(c); see supra note 37. A shareholder canwaive, too, but not in so all-encompassing and unilateral a manner: the typical waiverby a shareholder is in the form of a personal guarantee of the corporation's obligations.

As regarding optional management control, the articles of organization are tospecify whether the LLC is to be manager-managed. ULLCA § 203(a)(6).

90. See supra notes 28 & 37 for a discussion of corporate characteristics underfederal tax law.

91. See supra note 37 for a discussion relating to the tax treatment of LLCs, andsupra note 28 concerning limited partnerships.

first show that the fundamental differences between business formsare concentrated in the type and extent of the owners' exposure torisk. ULLCA's trigger mechanism, based on owner-management,inadequately reflects a recognition of these differences. In PartIII(A), I discuss the critical factors that have been implicitly recog-nized at common law to ascertain an applicable standard of perfor-mance: control and conflict, and risk and harm. Part III(B) describeshow the expansion of limited liability has unbalanced the equilib-rium created by common law. Finally, Part III(C) proposes a methodof assessing the level of an owner's duty that more accurately re-flects these very real differences than do the standards or the triggerproposed by ULLCA.

A. Business Forms and Risk Prior to RUPA and ULLCA:A Balanced Approach

When we consider the LLC, we must remember that the ownerwill have limited liability and may have management control.89 Fur-ther, because we have seen that the LLC form is used as a means ofobtaining both corporate limited liability and partnership tax treat-ment, under current federal tax law, the owners will seek to ensurethat at least two of the four corporate characteristics described bytax law are found lacking.90 As noted above, continuity of life, cen-tralized management, limited liability and free transferability ofinterests are those four characteristics.91 The LLC will almost cer-tainly satisfy the corporate criterion of limited liability. Therefore, ifan owner has management control which amounts to centralizedmanagement for purposes of federal tax law, the owners will almostcertainly wish to avoid both continuity of life and free transferabilityof their ownership. These limits on how widely the company is held


92. Realistically speaking, a business with all owner-managers is likely to haverelatively few owners and even those who are championing the LLC recognize that it isa form better adapted to such a situation. See, e.g., Keatinge et al., supra note 3, at 391.

93. Donahue v. Rodd Electrotype Co., 328 N.E.2d 505 (Mass. 1975) is a classic ex-ample, in the corporate context, of the difficulty of finding a market for ownershipparticipations, even if those participations are technically transferable.

94. Notice 95-14, 1995-14 I.R.B. 7.95. I.R.C. § 7704 (discussing treatment of publicly traded partnerships); see also 60

Fed. Reg. 21475, 21476 (May 2, 1995) (confirming that a publicly-traded LLC is taxed asis a “publicly traded partnership”).

96. See supra note 28 (describing the current law's characteristics).

will cause this type of LLC to resemble more a closely-held corpora-tion than a public corporation. If, on the other hand, every owner isalso a manager, so that there is no centralized management, therewill no longer be the same tax-law incentive to avoid free transfer-ability.92 In that case, even if the ownership is technically freelytransferable, there probably is only a very limited market for theownership interest.93 In either case, the owners are relatively lockedinto the business. The power wielded by the owners who individu-ally or as a group are in control can be particularly ominous, espe-cially, as discussed below, if the controlling owners are in a positionof conflict with those who have less control.

If the regulations contemplated by Treasury are proposed andapproved, to the effect that an election by the unincorporated busi-ness, irrespective of those four corporate characteristics, determineswhether the LLC, for example, is taxed as a partnership or a corpo-ration,94 the range of types of businesses run as an LLC may becomebroader. The principal limitation will be that the LLC seeking taxstatus as a partnership will have to avoid being publicly held.95 Itwill therefore become more likely that an LLC will have centralizedmanagement and free transferability of interests as well as limitedliability, as all these are defined in the current Treasury Regula-tions,96 than is the case today, although the truly publicly-held busi-nesses will probably continue to be in corporate form in most cases.Therefore, even if Treasury revises its tax treatment of unincorpo-rated businesses, LLCs will still tend to be relatively closely-held.

1. Control by the Active Owner


97. See generally Saballus v. Timke, 460 N.E.2d 755, 760 (Ill. App. Ct. 1983) (hold-ing managing partners to a heightened fiduciary duty); Donald J. Weidner, A Perspectiveto Reconsider Partnership Law, 16 FLA. ST. U.L. REV. 1, 21–22 (1988) (discussing theheightened duty when a managing partner is involved).

98. 328 N.E.2d 505 (Mass. 1975).99. 353 N.E.2d 657, 660 (Mass. 1977).

100. 422 N.E.2d 798 (Mass. App. Ct. 1981).101. 815 F.2d 429 (7th Cir. 1987), cert. dismissed, 485 U.S. 901 (1988).102. Claire Hansen was the Chairman of Duff & Phelps, Inc., and was also the per-

son who sought a lucrative merger for the company and dealt directly with the minorityshareholder-employee, Jordan. Jordan, 815 F.2d at 432. Mr. Hansen was also the chiefexecutive officer and largest shareholder. Smith v. Duff & Phelps, Inc., 891 F.2d 1567,1568 (11th Cir. 1990). Jordan has been viewed as a controlling shareholder case. See,e.g., Coffee, supra note 2, at 1680.

This concept of liability for controlling shareholders is not found only in Massa-chusetts law. See, e.g., Harriman v. E.I. Dupont De Nemours & Co., 372 F. Supp. 101,105 (D. Del. 1974) (holding that a controlling shareholder owes a fiduciary duty to corpo-ration and its shareholders).

103. ULLCA § 301(a) recognizes the apparent and actual authority of a member inlanguage virtually identical to that of RUPA § 301; the principal substantive differenceis that ULLCA breaks the RUPA language into two subsections.

A major variable in considering the standard of performance tobe imposed on an active owner of an LLC is the extent to which thatowner controls the situation. Presumably, ULLCA intended to re-flect this control factor when pivoting the applicable standards onthe extent of the owners' management. If the active owner manages,it can have a substantial impact on the complaining owner, and thatarguably should increase the active owner's responsibility.

Indeed, this concept is recognized in partnership cases, where apartner, who is also managing the business, is held to an especiallyhigh fiduciary duty.97 This understanding is also at the heart of closecorporation cases. In Donahue98 and in Wilkes v. Springside NursingHome, Inc.,99 the shareholder accused of breaching fiduciary dutywas the majority and controlling shareholder. In Smith v. AtlanticProperties, Inc.,100 the breaching shareholder was a minority share-holder found to be in control because of his absolute veto powergranted by various supermajority provisions. In Jordan v. Duff &Phelps, Inc.,101 the defendant shareholder was the largest singleshareholder and the chief executive officer of the corporation, and inthat sense was a controlling shareholder.102

Similarly, the member-manager of the LLC may be in control,at least to the same extent as a partner who is able to bind the busi-ness within the scope of the owner's authority.103 A non-manager


104. With respect to a person's status as a non-manager member for these purposes,see supra note 80 and accompanying text. The business forms also reflect that a person'sactual control should govern. A partner who has delegated management responsibilitybut nevertheless acts under apparent authority should be held to the fiduciary standard,which is presumably breached by the very fact of acting without actual authority. In thesame vein, the Donahue line of cases focus on actual effect, i.e., on power to act, ratherthan on any right to do so.

Nevertheless, under ULLCA § 409(h)(3), such a member in a manager-managedLLC would not have liability; this does seem to be a drafting error. See supra text ac-companying note 80.

105. Dickerson, supra note 5.106. See Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928).107. See Donahue v. Rodd Electrotype Co., 328 N.E.2d 505 (Mass. 1975).108. It is typical in such cases that any accommodation to the shareholder without

control is at the expense of the controlling shareholder. In Wilkes v. Springside NursingHome, Inc., 353 N.E.2d 657 (Mass. 1977), the controlling shareholders' refusal to payWilkes a salary meant that the corporation had more available income. It is not always

member would be more analogous to a minority shareholder in aclose corporation, and therefore not an owner with control. For thesepurposes, a person technically a non-manager member, but whonevertheless has apparent authority, should be considered an ownerwith control.104

2. Conflict of the Active Owner

Even if active owners have control, they do not necessarily havethe motive to use it to its full extent. The risk to the owner withoutcontrol increases as the active owner's incentive conflicts with theinterests of the owner without control. It is in these circumstancesthat the active owner's duty should be particularly high. This maybe inherent in ULLCA's concept of member-manager, but it deservesboth to be explicit and to be more subtle in application.

As I have commented elsewhere,105 the active owner's conflictincreases as the owner's investment in the transaction decreases. InMeinhard, the reason why Meinhard needed protection from Salmonwas not merely that Salmon had control over the business, but alsothat theirs was a zero-sum game. The more Salmon gave toMeinhard, the less was left for Salmon.106 Similarly, Harry Rodd, asthe controlling shareholder in Donahue, could not accomplish every-thing he wanted without cutting into Donahue's share.107 In Rodd'sperception, in order to receive a pleasant retirement and to providehis children with an affordable future in the company, he had toshortchange Donahue.108 Jordan is no different.109 If the chief execu-


so pure a zero-sum game, however. In Smith v. Atlantic Properties, Inc., 422 N.E.2d 798(Mass. App. Ct. 1981), paying the dividends requested by the noncontrolling majorityshareholders would subject the controlling shareholder, Dr. Wolfson, to higher incometaxes. However, Dr. Wolfson's refusal to consent to dividends created an indirect loss toall the shareholders when the Internal Revenue Service imposed the accumulated earn-ings tax on the corporation's undistributed income. Id.

109. Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), cert. dismissed, 485U.S. 901 (1988).

110. Dickerson, supra note 5, at 37–38; see also Smith v. Duff & Phelps, Inc., 891F.2d 1567, 1574 (11th Cir. 1990).

111. Indeed, the mere fact of being both an owner and a manager creates an inher-ent conflict. Despite the rigorous language of Meinhard v. Salmon, even in partnershipsthe existence of this conflict should not paralyze the actor-partner. See generallyDickerson, RUPA Fiduciary Duties, supra note 14, at 118. RUPA specifically providesthat an owner does not breach its duty merely because an act furthers its own interest.RUPA § 404(e).

Corporate common law similarly recognizes that ownership and managementcreate an inherent conflict. Wilkes, 353 N.E.2d at 663 and Smith, 422 N.E.2d at 801, ex-pressly allow the controlling shareholder to attenuate its fiduciary duty by taking intoaccount this shareholder's own legitimate business purpose. See generally supra note 48(discussing legitimate business purpose).

tive officer and dominant shareholder were to inform the minorityshareholder of the impending merger, the minority shareholderwould withdraw the redemption request and await the merger, orask for a larger payment. This larger disbursement would reducethe value of the corporation, and consequently also reduce the pricethat the prospective merger partner would be willing to pay to theremaining shareholders, including the dominant shareholder.110

The likelihood that the issue of conflict will become significantincreases as does the level of control. Owner-management meansthat some conflict is virtually inevitable,111 and that the potential todo harm increases as the owner-manager's control increases. What-ever the likelihood, however, conflict and control do not necessarilyincrease in direct proportion. Although it is difficult to generate ahypothetical person in control but without conflict, it certainly ispossible to contemplate a person who has conflict but no control. Forexample, an owner who lends to its own entity may not control, buthas a conflict. There is no reason why the standard of performanceof this owner, who has a conflict but no control, should be the sameas in Meinhard. A rigid rule that merely excludes all owner-lendersfrom fiduciary liability may, however, allow the pendulum to swingtoo far. What if the owner-as-lender in fact has control of the busi-ness — will not that fact increase the risk of true self-dealing at the


112. See generally Dickerson, supra note 5, Part II(B).113. An owner who is also a manager can have liability as a manager. See generally

supra note 97. The focus here, however, is on the owner's liability arising from the sta-tus and activities as owner.

114. In Donahue, the complainant sought to obtain the benefit of a market for theclosely held shares. The corporation and fellow shareholders constituted the only avail-able market to all indications, since neither the controlling shareholder nor thecomplainant had made any apparent effort to offer their shares to anyone else. 328N.E.2d 505 (Mass. 1975); Jordan, 815 F.2d at 433; Wilkes v. Springside Nursing Home,Inc., 353 N.E.2d 657 (Mass. 1977); Smith v. Atlantic Properties, Inc., 422 N.E.2d 798(Mass. App. Ct. 1981). The corporation and fellow-shareholders therefore represented theonly logical source from which Donahue as minority shareholder could obtain a returnfrom his investment.

115. See Wilkes, 353 N.E.2d at 661. The only distributions by the corporation to itsshareholders were in the form of salaries. When the corporation stopped paying a salaryto Wilkes, he lost the ability to receive any current return on his investment. Id.

expense of the business and the lender's co-owners?What is critical, therefore, is not whether the conflict and con-

trol are increasing at the same rate: it is important to know theextent of the conflict and control that in fact exists. Still missing is asystem that more smoothly and uniformly takes into account theactual level of control and conflict. The image is that of a continuum:as the aggregate of the owner-actor's control and conflict increases,so does that owner's standard of performance.112

3. Risk and Harm

The extent of control and conflict can be difficult to assess. Auseful point of view can be that of the victim. The complainant bydefinition has a perspective on its exposure to risk and harm at thehands of the active owner. Owners are exposed to different levels ofrisk in the various business forms depending on the extent of theirpersonal liability.113 There remains a very serious difference be-tween the two groups of cases.

On the corporate side, the Donahue line of cases concerns an al-leged abuse by the controlling shareholder that prevents the com-plainant from obtaining an adequate return on investment. Perhapsthe corporation's own assets create a market for the defendant'sshares, but not for the complainant's shares.114 Another abuse occurswhen the shareholder who discovered the business opportunity isfired, although salary has historically been the only way the share-holders have received any corporate distribution.115 Yet another


116. See Jordan, 815 F.2d at 432. The failure by the controlling shareholder to dis-close the probable merger caused the minority shareholder-employee to make decisionsthat deprived him of what the controlling shareholder knew to be part of thecorporation's inchoate value. Id. at 433.

117. See Smith, 422 N.E.2d at 800, where the distributions by the corporation to theshareholders had been small compared to the retained earnings. Id. Unless the corpora-tion made distributions, the non-controlling majority shareholders would receive no cur-rent return and the value of their investment would actually be reduced by the accumu-lated earnings tax imposed by the federal taxing authorities.

118. For a discussion of “harm,” see infra Part III(C)(1).119. See Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928). When Meinhard asked

to share in the new lease, he was in essence complaining that he was losing some of thepotential return to which he considered himself entitled. Id. at 547.

120. A shareholder's loss is not necessarily limited by its investment if the

possibility is that a corporation, through its largest shareholder,could encourage an employee to sell his shares to the corporation,knowing that a likely merger would give the remaining shareholdersa much greater return.116 In a more complicated case the defendantrefuses, for personal reasons, to acquiesce in any distribution to theshareholders. In that case, not only do the complainants receive noreturn, but they are also affirmatively harmed because the corpora-tion's large, undistributed income is subject to a penalizing accu-mulated earnings tax.117

Each of these cases, other than the last, concerns only the ques-tion of adequacy of the return. The last case does consider the harmto the shareholders, but only indirect harm: the direct loss belongsto the corporation because it is only the corporation's income that issubject to the accumulated earnings tax and only its assets that canbe called on to satisfy the tax liability. In other words, the “harm”118

suffered by the complainants in these cases includes the loss of areturn inherent in the corporation, and in the last case includes alsothe complainants' share in an actual loss of value to the corporationcaused by the defendant-shareholder's acts and omissions. Even inthis last case, however, the most that the complainants could lose istheir investment in the corporation.

In contrast, consider partnership-law cases. While their subjectmatter is the failure of one partner to permit the other to obtain anappropriate return on investment,119 the partnership cases speakrather of fiduciary duty. This difference could be for purely historicalreasons, but there may be a more satisfying explanation. In its ca-pacity as shareholder, the shareholder cannot lose more than itsinvestment in the business,120 while the partner can lose not only


shareholder's conduct is viewed as a breach of fiduciary duty. But then the “loss” is inthe form of a penalty imposed because of the breach, not because of any failure of thecorporation's business. See Perlman v. Feldmann, 219 F.2d 173, 178 (2d Cir.), cert. de-nied, 349 U.S. 952 (1955).

121. UPA §§ 13–15. This result is unchanged under RUPA §§ 305–306.122. However, the owners of a corporation could be partners if the corporate veil is

pierced and the owners' relationship independently satisfies the elements for partnershipformation. UPA § 6; RUPA § 202.

123. See generally supra Part II(B)(1). Concerning the “selfish ownership” of share-holders, see, e.g., Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657 (Mass. 1977).

124. See supra note 49 and accompanying text.125. 422 N.E.2d at 800. See supra note 48 describing Dr. Wolfson's legitimate busi-

ness purpose in Wilkes. Dictum in Wilkes suggests that Dr. Wolfson can still be heldaccountable if the non-controlling shareholders carry the burden of showing that Dr.Wolfson could have attained his purpose without hurting them as much. Wilkes, 353N.E.2d at 663. Dr. Wolfson should have refuted the non-controlling shareholders' accusa-tion of breach of fiduciary duty by showing that his business interest of reducing hisown tax exposure was incompatible with the non-controlling shareholders' desire for adistribution. However, Dr. Wolfson would still lose if the non-controlling shareholderscould show that Dr. Wolfson could have protected that assumedly legitimate business

that investment, but also the partner's separate assets.121 If part-nership income were subject to a tax penalty, the personal assets ofthe owners are at risk, not just their investment in the business.

Add to this unlimited exposure the fact that in partnership lawrisk can be imposed on a person who subjectively does not want it,thereby increasing the risk. Incorporation can eliminate this risksince an incorporated business by definition is not a partnership.122

Therefore, the risk belongs exclusively to the general partnershipform.

Historically, the law has reflected this difference by imposing alower level of responsibility on the shareholder than on the partner.While the partner must act with the utmost good faith, theshareholder's right to “selfish ownership” tempers the impact of anyfiduciary duty on the shareholder.123 Specifically, the Donahue-cre-ated common-law line of analysis recognizes that the controllingshareholder, who would otherwise have a fiduciary duty, is excusedif this controlling shareholder can show a “legitimate business pur-pose” for its acts.124 This purpose is related to the business of theshareholder, not of the corporation, which further underscores theshareholder's right to consider its own personal interests. For ex-ample, in Smith, it appears that the defendant-shareholder's legiti-mate business purpose was his desire to reduce his personal taxexposure.125


purpose by a sufficiently detailed regimen of repairs and improvements without hurtingthem through imposition of accumulated earnings tax on the corporation. The Smithcourt indicated that the corporation would be instructed to pay dividends if the financialsindicated that it was in a position to do so: there was a less harmful means, Dr. Wolfsondid not pursue it, and dividends would therefore be paid. 422 N.E.2d at 803–04. Thecourt may have faced a very basic conflict and concluded that Dr. Wolfson could haveprevented the current return on investment to the non-controlling shareholders if he hadprepared a detailed proposal for avoiding the accumulated earnings tax. Id. While thecourt would be protecting the non-controlling shareholders' ultimate return on invest-ment by eliminating the corporation's tax penalty, it would not be protecting thoseshareholders' interest in receiving a current return. Id.

126. See supra notes 66 & 67 (discussing RUPA §§ 404, 103).127. See supra notes 72 & 73 (discussing ULLCA §§ 409, 103).

Therefore, the common law has at least implicitly recognizedthat a consequence of choosing the corporate form over the partner-ship form is the reduction of risk, and therefore the reduction of theharm that an owner can suffer. The extent of potential harm to ashareholder is lower than to a partner since only the former is pro-tected by limited liability, and the protection of fiduciary duty hashistorically been greater for the partner.

B. Evolution of Limited Liability in Business Forms and theUnbalancing of Fiduciary Duty

As a practical matter, the fiduciary obligation of an active ownerprior to RUPA and ULLCA did reflect an effort to take into accountthe active owner's motive and opportunity to do harm. RUPA modi-fies this result somewhat, by allowing the parties to negotiate areduction of fiduciary duty, down to a level of good faith;126 this dis-rupts the balance of the continuum that had been evolving under thepre-RUPA partnership law and corporate law. ULLCA does thesame, compounding the impact by granting limited liability to theowners.127

1. Evolution of Limited Liability

In the trend leading to close corporations on the one hand, andfrom general partnerships to limited partnerships on the other, themove has been away from unlimited liability for an owner-manager.The original reason for allowing the owners of corporations to havelimited liability was to encourage fund raising. If new owners do nothave to worry about personal liability, they will be more willing to


128. The limited liability that appeared toward the middle of the nineteenth centurywas seen as a way of encouraging investors of moderate means. See, e.g., Stephen B.Presser, Thwarting the Killing of the Corporation: Limited Liability, Democracy, andEconomics, 87 NW. U. L. REV. 148, 155 (1992); see generally MICHAEL P. DOOLEY, FUNDA-MENTALS OF CORPORATION LAW 37 (1995).

129. See generally DOOLEY, supra note 128, at 38. Without limited liability, share-holders would have to monitor management more carefully. See, e.g., Rogers E. Meinerset al., Piercing the Veil of Limited Liability, 4 DEL. J. CORP. L. 351, 362–63 (1979).

130. The original nineteenth century model was different. It envisaged the entrepre-neur who would “directly invest in and manage a corporation.” Presser, supra note 128,at 174. However, since the beginning of the twentieth century, the separation of owner-ship from management has been described as “traditional” although less representativeof publicly or closely held corporations today. See CARY & EISENBERG, supra note 40, at206–07; see also Lawrence E. Mitchell, Close Corporations Reconsidered, 63 TUL. L. REV.1143, 1150 (1989) (suggesting that, because limited liability in the hands of the managerwill encourage morally questionable behavior, close corporations should be reconfiguredto grant limited liability only to those who do not manage).

131. The statutes say that the Board manages. See, e.g., DEL. CODE ANN. tit. 8, §141(a) (1991). It is the courts that linked liability and responsibility. See, e.g.,Charlestown Boot & Shoe Co. v. Dunsmore, 60 N.H. 85 (1880). Some state statutes havesubsequently followed suit with a similar, explicit expression of the linkage. See, e.g.,DEL. CODE ANN. tit. 8, § 350 (1991).

132. Even the statutes that do not specialize in close corporations recognize thisform. See, e.g., DEL. CODE ANN. tit. 8, §§ 141–142 (1991).

invest even in relatively risky ventures.128 The corporation would beable to raise more capital because the investors would pay relativelymore, in part because their risk would be reduced, and in part be-cause they would then affirmatively spend less on monitoring.129 Thequid pro quo, in effect, was that the owner would not have manage-ment say.130 If the shareholder had management say, then responsi-bility should follow; this was the reason for the cases that have care-fully distinguished between the role of the owners and of the direc-tors.131

In time, however, the practical needs of businesses pushingfrom one end, and technical analysis pushing from the other, hasresulted in the approval of even the corporation with a single share-holder who is also the only officer and director.132 Although thisshareholder as owner benefits from limited personal liability, theshareholder will, in an admittedly different capacity, also be man-aging the business. At least in the corporate arena, the mutualexclusivity of management and limited liability has therefore beenbroken. Nevertheless, the corporate formalities must be respected. Ifthe sole managing shareholder treats the corporation as a personalwallet, the corporation may be identified as a sham, and the share-


133. For a representation of criteria for piercing the corporate veil, see Walkoszky v.Carlton, 223 N.E.2d 6 (N.Y. 1966). There has been considerable scholarly attention tothis topic. See, e.g., Robert B. Thompson, Piercing the Corporate Veil: An EmpiricalStudy, 76 CORNELL L. REV. 1036 (1991). For our purposes, however, it is sufficient toknow that the limited liability provided by corporate status is not inviolable.

134. As to the partner's management right, see UPA § 18(e), (h); RUPA § 401(f), (j).That the right to management is inherent in the partnership interest, see the co-owner-ship element of UPA § 6(1) and the virtually identical RUPA § 202(a). The comment toUPA § 6 states in part: “Ownership involves the power of ultimate control. To state thatpartners are co-owners of a business is to state that they each have the power of ulti-mate control.” UPA § 6 cmt. 1.

135. UPA §§ 13–15; RUPA §§ 305–306.136. ULPA § 7 (1916).137. ULPA § 7 provided no guidance to the limited partner: it only said that the

limited partner would lose the protection of limited liability if it “takes part in the con-trol of the business.” Id. The only safe harbors available were found in the express listof ULPA § 10 that inter alia permitted the limited partner to receive information.

138. RULPA § 303; see DEL. CODE ANN. tit. 6, § 17-303 (1993); see also supra note16 discussing § 17-303.

holder may lose the protection of limited liability.133

From the other end of the business organizations spectrum, thesame trend toward conferring limited liability on owner-managershas been emerging. A partner in a general partnership has the rightto manage; even if delegated away by agreement, the right is inher-ent to the partnership interest.134 That general partner also hasunlimited personal liability.135 The first unincorporated hybrid, au-thorized by the state statutes patterned on the 1916 Uniform Lim-ited Partnership Act (ULPA), allowed certain owners, nominallypartners, to have limited liability.136 However, ULPA made it verydifficult for these so-called limited partners to maintain limitedliability if they exercised any significant control.137 This is one of theareas of important change brought by the Revised Uniform LimitedPartnership Act (RULPA), especially as adopted in a number ofimportant commercial states such as Delaware and New York.

A corporation can be the sole general partner, and now the lim-ited partners, without losing the protection of limited liability, canbe the sole shareholders, the sole directors and the sole officers ofthat corporate general partner, and can even be active in those ca-pacities.138 Although technically the corporate general partner willhave all of its assets at risk, these assets can be kept to a minimumso that, in practical effect, the owners have limited their liabilityand maintained full management control over the limited partner-ship. Nevertheless, there is a sense that the limited partners must


139. This is necessary to satisfy the safe harbors of the applicable state law basedon RULPA § 303. See supra note 28 concerning the criteria to ensure treatment as apartnership for federal tax purposes.

140. This ensures that the corporate general partner's veil is not pierced. See supranote 133 concerning corporate veil piercing.

141. ULLCA § 303; see supra note 21.142. It has also spawned questionable progeny. For example, New York's new reg-

istered limited liability partnerships are technically partnerships, but they protect theprofessionals who are the partners from liability to the same extent as professional cor-porations protect their shareholders. Compare N.Y. PARTNERSHIP LAW § 26 (analogue toUPA § 15), §§ 121–1500 (McKinney Supp. 1995) (registered limited liability partnerships)with N.Y. GEN. BUS. LAW § 1501 (McKinney 1993).

143. But see Keatinge et al., supra note 3, at 445–46. Colorado has by statute pro-vided for piercing. COLO. REV. STAT. § 7-80-107 (Supp. 1994). ULLCA has no such ana-logue, and limited partnerships are not considered to be subject to piercing. Wayne M.Gazur & Neil M. Goff, Assessing the Limited Liability Company, 41 CASE W. RES. L.

be careful if they are to protect their limited liability while alsomanaging the business, albeit indirectly. They must be careful of theformalities to ensure both that the limited partnership's manage-ment is nominal by the corporate general partner,139 and that thecorporate formalities of the general partner also are respected.140

Into this scene steps the LLC. Without apology or ambiguity,the statute grants all its members the privilege of limited liability,even if they are managers.141 This complete integration of manage-ment rights and limited liability could be properly accomplishedonly by statute; indeed, the LLC may signal the end to unlimitedpersonal liability.142 The consequence to the level of duty owed isprofound: if the owners are protected from unlimited liability even ifthey manage, and this with little risk of error because the benefits ofthe LLC are inevitably available upon filing the statutorily-man-dated formation papers, then the risk suffered by a member of anLLC is much less than that of a partner in a general partnership, orof a limited partner in a limited partnership. It is less even than therisk of a shareholder in a closely held corporation. It is less than if ageneral partner because the member in an LLC has limited liability.It is less than if a limited partner because the member in an LLCdoes not risk losing the protection of limited liability when itexercises management control. It is less than if a shareholder in aclosely held corporation to the extent that the LLC is relatively un-likely to be recharacterized as a general partnership, since theULLCA contains no clear analogue to the common-law concept ofpiercing the corporate veil.143 According to the common-


REV. 387, 402 (1991). Perhaps, as in Colorado, the LLC should not be subject to piercingat all, absent a Colorado-type statute. However, the LLC may be more similar to thecorporation than to the limited partnership because both permit owners to manage. Id.at 402–03; Keatinge et al., supra note 3, at 445. Neither is required to have an ownerwho even nominally has unlimited liability. Gazur & Goff, supra, at 402–03. Perhaps,therefore, the LLC should be subject to piercing. But even if it is, it occurs as frequentlyas in a corporation because formalities are less important for LLCs than for corpora-tions, and it will not be possible to argue for piercing because of failure to hold regularboard meetings. What will be required are specific facts that indicate the owner's basicand generalized disregard of the LLC's separate existence.

144. See supra Part III(A)(2).145. See supra Part II(C).146. See supra Part III(A)(2).147. ULLCA § 409(e); see supra note 66 (discussing RUPA § 404(e)); see also supra

note 45 (discussing the legitimate business purpose exception).148. ULLCA § 409(e).

law's logic described above in Part III(A)(3), the LLC's owners wouldshoulder a fiduciary duty no higher than would a close corporation'ssimilarly situated shareholders.

2. Control and Conflict

ULLCA does take into account the relationship between controland conflict on the one hand, and responsibility on the other, but itis an instrument far more crude than the common-law approachdescribed above in Part III(A)(1) and (2). A member in an LLC canhave a position of conflict just as can a partner or a shareholder:144

to that extent, the fact of owner-management as a trigger that in-creases the responsibility and liability of the owner makes sense.145

The ULLCA's method is crude because it does not directly take intoaccount the inevitable conflict of an owner-manager,146 and becauseit imposes a flat obligation regardless of the level of actual control orconflict. ULLCA corrects for conflict at the low end by allowing themember-manager to engage in selfish acts: a member-manager isnot automatically in violation of its duties merely because its activi-ties benefit it personally.147 This language does not tell us much,however. When does a member's conduct do more than “merely . . .further[] the member's own interest”?148

On the high end of conflict, ULLCA is just as blunt a tool be-cause whatever the likelihood, conflict and control do not necessarilyincrease in direct proportion. We saw, for example, that an ownerwho lends to its own entity may not control, but has a conflict; flexi-


149. See supra Part III(A)(2).150. ULLCA § 409(f). RUPA contains the same provision for a partner-lender. RUPA

§ 404(f).151. See supra Part III(A)(2).152. See generally Dickerson, supra note 5, Part II(B).153. See supra Part III(A)(3).

bility would therefore be appropriate.149 Indeed, ULLCA recognizesthat the owner-management trigger can lead to inappropriate re-sults because the statute expressly excludes an owner-as-lenderfrom fiduciary liability.150 But what if the owner-as-lender in factdoes have control of the business — will not that increase the risk oftrue self-dealing at the expense of the business and the lender's co-owners?151 How do we create a system that more smoothly and uni-formly takes into account the actual level of control and conflict,where an increase in the aggregate of the owner-actor's control andconflict serves to increase the active owner's standard of perfor-mance?152

C. Reintroducing Balance by Recognizing Permitted Harm in theContext of Control and Conflict

When discussing the evolution of the different standards forpartnerships and close corporations, I noted that partners can suffermore harm than shareholders, because the former do not benefitfrom limited liability, and can lose far more than their investmentplus any potential upside.153 The purpose of that discussion was tooutline existing law and to consider how the concept of “harm” isimplicit in the common law's imposition of a higher standard onpartners than on shareholders, as they deal with co-owners. Howev-er, our focus on the LLC has now trained our sights directly on lim-ited liability, and on harm. If we are to use this concept of harmmore explicitly as a means of placing the appropriate standard ofperformance on a continuum, we must articulate what we mean by“harm.” We will look at “permitted” harm and “potential” harm andhow these concepts fold back onto the control-conflict continuum.Finally, I will discuss why the standard of performance arrived at inthis manner must be mandatory, not optional.

1. Harm, Permitted Harm and Potential Harm


154. For a more detailed discussion of “harm” and of the contractarians' analysis,see Dickerson, supra note 5, Part II(a)(1).

155. Contractarians are generally called lawyer-economists. A classic lawyer-econo-mist and contractarian is, for example, Judge Posner. See supra note 52.

156. See, e.g., POSNER, supra note 51, § 1.2, at 13–15; JULES L. COLEMAN, MARKETS,MORALS AND THE LAW 71–72, 84–86 (1988); Jules L. Coleman, Efficiency, Utility, andWealth Maximization, 8 HOFSTRA L. REV. 509, 512–13 (1980). An allocation of resourcesthat hurts no one and that causes at least one person to be improved is Pareto superior.If no possible Pareto superior allocation exists, the allocation is Pareto optimal. Coleman,supra, at 512–13. Kaldor-Hicks efficiency exists when the benefit to the winners wouldexceed harm to the losers, if the winners compensated the losers. Id. The losers do notin fact have to be compensated: if they were, the allocation would become Pareto superi-or. Id. at 513.

157. See Dickerson, supra note 5, Part II(A)(1); see generally Ronald H. Coase, TheProblem of Social Cost, 3 J.L. & ECON. 1 (1960).

158. See, e.g., Butler & Ribstein, supra note 1, at 40.159. See supra notes 52–54, Part II(C).160. Contrary to Judge Posner's example of the firebreak, POSNER, supra note 51, §

6.9, at 190–91, this externality would be negative; see generally Dickerson, supra note 5,Part II(A)(1).

a. Harm

As I have indicated elsewhere,154 the scholars who have consid-ered harm most closely are the contractarians.155 In their concern foreconomic efficiency, the contractarians view relationships in termsof costs.156 A cost to which the parties have freely agreed is not harmto the parties who bargained for that cost.157 If a mandatory stan-dard of performance is imposed on the parties, whether at somefiduciary level or lower, the parties may have an increased cost sincethey would not have willingly chosen to bear the higher cost of per-forming to the relatively higher standard.158 Because the parties'competitors will be similarly burdened, the parties will be able topass at least some of the costs on to their consumers. Ultimately,however, society will suffer because of the inefficient allocation ofsocietal resources, and for that reason contractarians generally de-plore mandatory duties.159 But even if society is harmed, theindividuals would not be, since they have passed on their costs.160

Therefore, the contractarians see no harm to the individual partieswhether or not fiduciary duties are imposed: if the duties are notmandated, the parties freely agree to any cost; if the duties are man-dated, it is society and not the individual parties that are harmed.

If that is the contractarian perspective in brief, it still neglectsactual harm that can be suffered when fiduciary duties are not


161. See, e.g., POSNER, supra note 51, § 4.1, at 93.162. Such contractarians as Professor Ribstein emphasize the relative sophistication

and general ability of parties to decide freely. See, e.g., Ribstein, supra note 13, at 59.163. See, e.g., Easterbrook & Fischel, Close Corporations and Agency Costs, 38 STAN.

L. REV. 271, 274 (1986).164. Dickerson, supra note 5, Part II(A)(1).165. See generally id., Part II(A)(2).166. See, e.g., Oliver Wendell Holmes, The Path of the Law, 10 HARV. L. REV. 457,

462 (1897) (illustrating the efficient breach of contract).167. A victim has no tort cause of action because of lack of proximate cause. See,

e.g., Kinsman Transit Co. v. City of Buffalo, 388 F.2d, 821, 824 (2d Cir. 1968). Addition-ally, damages suffered do not give rise to a cause of action because they were unfore-seeable. See, e.g., Hadley v. Baxendale, 156 Eng. Rep. 145 (Ex. 1854); RESTATEMENT

(SECOND) OF CONTRACTS § 351 (1979).

mandatory. We have seen that, in the case where there are no man-datory standards, the contractarians base their conclusion of noharm on the assumption of free bargaining.161 The free bargainingassumption requires the further assumption of a level playingfield.162 But, as I noted elsewhere, what if the parties are not evenlymatched? For example, the owner of a closely-held business willtend not to have diversified and therefore to be in a weak positionunless it is also the owner with control.163 A weaker party will havegreater costs than its competition, either to purchase fiduciaryprotection if not mandated, or to monitor if the protection is notavailable. This increased cost, due to the party's relative weakness,will be felt as harm.164 It is for this reason that each party's behaviormust meet some minimum threshold.

b. Permitted Harm

Permitted harm describes the extent of harm that society willallow one person to inflict on another,165 and helps to define theproper level at which to set the threshold. Permitted harm does notdescribe the harm that a person can “get away with,” in the sensethat certain losses may give rise to a technical cause of action butnot allow the victim to obtain recovery because, as a practical mat-ter, the cost of litigation is prohibitive in the context.166 Neither doesit focus on a bad act for which there is no remedy because the injuryis considered too remote.167 Rather, it focuses on acts that do harmanother, but that are permitted. For example, a person who has notacted negligently can harm another, but, absent strict liability, that


168. There could still be a cause of action outside tort law. See, e.g., Sullivan v.O'Connor, 296 N.E.2d 183 (Mass. 1973) (holding that the defendant was not negligent,but was liable in contract).

169. Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928). Judge Cardozo expressly foundthat Salmon had acted in good faith. Id. at 547.

170. In the agency context, see, e.g., Tarnowski v. Resop, 51 N.W.2d 801 (Minn.1952). In the partnership context, see, e.g., UPA § 21(1), holding the partner expresslyaccountable for the type of kick-back that was the subject of Tarnowski. The result isthe same under RUPA § 404(b)(1), subject to any agreement pursuant to RUPA §103(b)(3) limiting the duty. In the corporate law context, see, e.g., Diamond v.Oreamuno, 248 N.E.2d 910, 912–13 (N.Y. 1969) (Fuld, C.J.) (considering that thecorporation's reputation had been damaged).

171. Dickerson, RUPA Fiduciary Duties, supra note 14; Dickerson, supra note 5.

act will be permitted.168 Acts that comply with applicable standardsof performance also can give rise to permitted harm. Although JudgeCardozo found that Meinhard did suffer harm for which there was aremedy, if the court had not considered the relationship of Meinhardand Salmon to be substantially equivalent to a partnership andtherefore governed by fiduciary duty, Salmon's act of entering intothe lease would have been permitted, regardless of any harm in-flicted on Meinhard.169

By considering the extent of harm that society permits if it ap-plies a particular standard of performance, we have another methodof assessing ULLCA. In this context, the harm permitted is bothactual harm and potential harm.

c. Potential Harm

Especially at the higher levels of the standards of performance,for example in the context of fiduciary duty, actual harm does nothave to be proved for recovery to be allowed. Put differently, poten-tial harm is sufficient.170

As the standard of performance falls, the amount of permittedharm, especially potential permitted harm, rises, all other things be-ing equal. But they are not. If the victim is subject to unlimited per-sonal liability the permitted harm potentially generated will begreater than if the same standard were applied and the victim wereprotected by a limitation on personal liability. I am already on re-cord as criticizing RUPA's reduction of fiduciary duties as beinginappropriately low for general partnerships.171 My view is un-changed. But these same standards may at least as a first cut beappropriate for an LLC that protects its owners from unlimited per-


172. Dickerson, supra note 5, Part II(C)(1).173. Id.174. See supra Part III(C)(1)(b) for a discussion of permitted harm.175. See Dickerson, supra note 5, Part II(A).176. See id. Part II(B)(2).

sonal liability, precisely because the same standard of performanceapplied to owners of an LLC permits less harm than it does if ap-plied to fully exposed general partners.

2. The Refinement Based on Permitted Harm, and onControl and Conflict

The form of the business should determine presumptive stan-dards for providing guidelines.172 This creates a continuum with de-finable points based on the nature of the business that providesinitial predictability. A partnership relation would be presumed togive rise to a high standard, but a corporation's owners would bepresumptively subject to a lower standard, in each case subject tothe refinement that the victim can overcome the presumption byshowing that in the particular circumstance the resultant permittedharm is inappropriate.173 The presumptive standard for the corpora-tion should be lower, as indeed case law has provided, because theharm that can potentially be inflicted on a shareholder has an auto-matic ceiling equal to the shareholder's investment in the business.It is only the portion of this potential harm truly permitted by ourlegal system that would then be considered permitted harm.174 Forexample, if the active owner's act that could give rise to harm iswithin the applicable standard of performance, even if the harm isstill potential, that entire loss would be permitted harm subject to aceiling if the owner has limited liability. Thus, the maximum possi-ble permitted harm is limited if the business organization provideslimited liability, as does the corporation and the LLC.

To use only permitted harm as a means of smoothing the quan-tum aspect of a spectrum that leaps from business form to form, forexample from partnership to limited partnership to corporation, isto ask too much of that concept. Permitted harm is a means of hear-ing the victim,175 but it inevitably has a subjective flavor. The way toinclude more purely objective factors is to look at the extent of con-trol of the active owner and its conflict. These factors act as a checkon the victim's perception of harm.176


177. Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), cert. dismissed, 485U.S. 901 (1988).

178. See supra Part III(A)(2), (B)(2), for a discussion of the owner-as-lender.179. See, e.g., Ribstein, supra note 13, at 57–61.180. See Dickerson, supra note 5, Part II(B)(2),(3).181. See generally supra Part II(C).182. For the text of ULLCA § 409(b), see supra note 72; see also Kennedy, supra

note 84 (concerning the effect of exclusive lists as opposed to standards).183. For the text of ULLCA § 103(b), see supra note 73.

The greater the active owner's conflict and control, the morelikely is the accuracy of the victim's perception of at least some suf-fered harm. The greater the actual or potential harm, the less likelythat society can permit the conduct, since it would be legitimizingabuse. Therefore, the conflicted controlling shareholder in Jordan,177

because his position creates the potential for harm, will be held to ahigher duty than if he had no control. A partner who lends to thepartnership but has delegated away all management rights wouldowe a heightened standard because of the conflict inherent in thetransaction, but not the highest standard because of the active part-ner's lack of control (and the partner's resultant reduced ability toharm).178

3. Permitted Harm Standards of Performance as Mandatory

Once the presumed standard of performance has been estab-lished based on the business form, and once this standard had beenrefined by taking into account the control and conflict of the activeowner and the extent of the permitted harm at that level of stan-dard, the standard must be mandatory. While this is undeniablydifferent from the view of the contractarians,179 it is mandated bythe permitted harm analysis that depends on the relative positionsof the parties and assumes a playing field that is most likely notlevel. If, once the standard had been established, the parties wereable to opt out, it would only give the active owner, who in thesehypotheticals has been the person with control, another opportunityto exercise that control.180

This conclusion is different from what ULLCA provides.181 Notonly does the statute narrow the definition of fiduciary duties byincluding an exclusive list,182 but it also permits further opting outby the parties.183


184. Fiduciary duty and good faith are on the same continuum. See Dickerson, supranote 5, Part II(B).

185. See supra Part II(A).186. Donahue v. Rodd Electrotype Co., 328 N.E.2d 505 (Mass. 1975). See supra Part

III(A), describing the common law standards as balanced.

4. Permitted Harm Analysis Applied to LLCs

We have created a sliding scale for the standards of perfor-mance.184 What does this analysis add to our review of the LLC?

The bad acts considered so far by the permitted harm analysisare abuse by the controlling shareholder or by the active partner. Inthis context, the analysis will not allow a reduction in the owner'sobligation. Now let us see what happens if the bad actor is an ownerof an LLC. The structure of the LLC limits the potential harm to anowner-victim in much the same way as the corporate structure lim-its the risk to which a shareholder is exposed. Since an LLC cannotbe formed by inadvertence, the likelihood of imposing on an ownertotally unexpected liability is less than for partners. Further, anLLC will tend to have few owners although, if Treasury adopts newregulations that substitute an election for the current analysis offour corporate characteristics as the way of determining the LLC'stax status, the LLC may in the future have a relatively greater num-ber of owners than today.185 An LLC member should, therefore, havethe same level of responsibility as a similarly-situated shareholderin a close corporation. A member who is also a manager should besubject to the delicately balanced common-law duty of a controllingshareholder186 — and this duty should be mandatory and irreduc-ible. Unfortunately, this is not the analysis of ULLCA.

ULLCA reproduces the objectionable contractarian terms ofRUPA that allow the general partners to reduce their obligation byagreement down to a level of good faith. Under ULLCA, the mem-bers of an LLC have the same ability to opt out, whether or not theyare managers. What makes this statutory intervention less shockingin the context of LLCs than in general partnerships is that the lim-ited liability of the LLC members places a ceiling on the permittedharm they can suffer due to obligations created by a co-owner. If theparties can and do negotiate an enforceable reduction in the stan-dard of performance, the harm permitted to be inflicted by a partneron its co-partners is potentially far greater than the harm inflictedby a member of an LLC on its co-members: the partners have unlim-


187. See supra notes 128–33 and accompanying text for a discussion of the effect oflimited liability on an owner's risk.

188. See Dickerson, RUPA Fiduciary Duties, supra note 14; Dickerson, supra note 5.189. A slight variation can be justified in proportion to the greater difficulty in

piercing an LLC as opposed to corporate veil, see supra note 143 and accompanying text,but the difference here is gross.

On a more general point, while both the contractarian majority and the dissentin Jordan believed that the parties can opt out of whatever fiduciary duty would other-wise restrict the controlling shareholder, Jordan v. Duff & Phelps, Inc., 815 F.2d (7thCir. 1987), cert. dismissed, 485 U.S. 901 (1988), it is not at all clear when evencontractarians would apply a contract-law standard to a shareholder in control. Id.; seesupra note 52 (discussing the views of Judge Easterbrook in the court's opinion, as com-pared with those of Judge Posner in his dissent). The conclusions of Judges Easterbrookand Posner in this case can be harmonized as different views of the standard to be ap-plied to waiver of fiduciary duty or differing views as to the duties themselves. JudgePosner considers them to exist if any contract has been entered into by the parties, onlyif the contract so provides, while Judge Easterbrook views duties as default provisions,applicable unless clearly eliminated by agreement entered into by the parties. SeeDickerson, supra note 5, at 974 n.76.

190. See generally supra Part II(B)(2); see also Part II(A)(2). Historically, courts haveseemed more willing to find that an owner exercising a veto, is exercising control if thebusiness is incorporated rather than unincorporated. The LLC should be considered morelike a corporation, but we do not have sufficient experience with the LLC to know howthe courts will deal with vetoes where the statute is silent. Compare Smith v. AtlanticProperties, Inc., 422 N.E.2d 798 (Mass. App. Ct. 1981) (treating a vetoing shareholder asa controlling shareholder) (see supra note 94 and accompanying text) with Martin v.Peyton, 158 N.E. 77 (N.Y. 1927) (stating lenders exercising veto power are notrecharacterized as partners, and are not personally liable).

ited personal liability, while the LLC members stand to lose onlytheir investment and any upside.187 Even if an LLC managing mem-ber's control is relatively great, the victim's harm still is limited bythe structure of the entity. Therefore, the manager-owner of an LLCcan legitimately be subjected to a lower standard of performancethan for a partner.188

However, there are consequences of ULLCA that I cannot ac-cept. Because of its unsubtle trigger, ULLCA standards of perfor-mance may result in an automatically and uniformly lower standardfor a member of an LLC than for the controlling shareholder in aclosely-held corporation.189 ULLCA's trigger defined by the extent ofan owner's official, as opposed to actual, status as manager, maymean that a person in actual control of an LLC will not be subject toany fiduciary standard. The problem may be particularly acute if thenon-manager owner is exercising control through veto: it is not at allclear that this person will be recognized as a manager.190 Further, ifa fiduciary standard does apply initially to the LLC owner, the draft


statute allows the parties to opt out without taking their relativepositions into account. ULLCA is not even procedurally responsiveto conflict and control, beyond the trigger, when addressing the veryserious issue of standards of performance. It does not recognize thatthe complaining owner will be more susceptible to harm if the busi-ness is relatively closely held and, therefore, the complaining ownerwill typically not have diversified. In contrast, the permitted harmanalysis that I have outlined in Part III is substantively and auto-matically responsive even to the LLC's status as a limited liabilityform. Before effecting the fine-tuning that would take into consider-ation the extent of the member-manager's actual control and con-flict, the permitted harm analysis would factor in the LLC's charac-teristics. Because the extent of the permitted harm that an LLC-member can suffer is capped by that person's limited liability, thestandard applied to an owner-actor in an LLC, i.e., to a member-manager, would presumptively be lower than that applicable to apartner in a general partnership. After that presumptive level forthe standard has been determined, the permitted harm analysisfactors in the active owner's control and conflict, and considers theharm that a particular standard would permit that active owner toinflict on the co-owner. The standard of performance thus deter-mined is mandatory.

Unless the standard of performance varies depending on theactive owner's control and conflict, and on the harm that the activeowner can inflict, ULLCA facilitates abuse. The owner-manager issheltered from personal liability to third parties. If the owner-man-ager convinces its co-owners to agree to allow it to opt out of dutiesdown to the good faith threshold of ULLCA, the owner-manager willalso have minimal liability to co-owners. Any act that would be per-missible by an arms-length party to a garden variety contract maywell be permissible if effected by an opting-out owner, even if also amanager and even if the non-managing co-owner is particularlyvulnerable. Co-owners would thus suffer harm without a right to aremedy.

IV. CONCLUSION


191. See supra Part III(C)(2).192. The provisions of ULLCA §§ 409, 103 are virtually identical to those in RUPA

§§ 404, 103. Compare text at notes 72 & 73 with text at notes 66 & 67.

The most radical change represented by the LLC is its severingof an owner's responsibility from its liability, in the context of anunincorporated business. The LLC's structure provides that a mem-ber of an LLC can be a manager and still have limited personal lia-bility in its capacity as owner. This change in turn should have animpact on the extent of fiduciary duty owed by one owner to another.

In the context of a business entity that provides limited liabilityto its owners, ULLCA allows for opting out of fiduciary duty, downto a good faith level, again, even for members who are also manag-ers. Members who are not deemed managers owe no fiduciary dutywhatsoever to their co-owners. This reverses a trend in the law ofclose corporations: depending on how management is defined, anLLC member acting as would a controlling shareholder, might notbe considered a manager.191

In addition to that technical problem, ULLCA errs far morefundamentally by using management as the trigger. That triggerapplies only a small portion of one out of three relevant factors thatdistinguish the various business forms from each other. To the ex-tent that management is a subset of control, the control factor is notfully covered, and the factors of conflict and potential to inflict harmare covered, if at all, only to the extent subsumed in the concept ofmanagement. The permitted harm analysis reintroduces these fac-tors, and mandates the resultant standard of performance. Other-wise, we are merely inviting further abuse, to be judged at thelower, contract standard of good faith.

ULLCA treatment of fiduciary duty succeeds in that it recog-nizes that the presumptive level for the standard of performanceneed not be as high as for partnerships under pre-RUPA partner-ship law. Given that ULLCA's starting point is apparently RUPA,192

ULLCA arguably sets a high moral tone: it applies the same stan-dards to owner-managers of LLCs as RUPA does to partners, eventhough the potential loss of an LLC member is less than that of ageneral partner. However, ULLCA fails in the bigger picture. It hascreated a standard of performance for members of an LLC that iseven lower than the standard currently in place for the owners inthe traditional business entity having limited liability, the corpora-


tion. Further, it does so in a context where tax considerations limitthe number of owners, thereby increasing the vulnerability of theowners who lack control.

Unless we revise ULLCA's standard of performance to take intoaccount the active owner's control and conflict, and its potential toinflict harm, the LLC will become the vehicle of choice for all whowish to avoid responsibility.

Documents

EQUILIBRIUM DESTABILIZED: FIDUCIARY DUTIES UNDER THE UNIFORM LIMITED LIABILITY COMPANY ... · 2017-12-21 · Before 1990, Florida and Wyoming were the only LLC jurisdictions. Rob-ert